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Listening to several bank conference calls this earnings season, a repeating theme emerged in analysts' questions: Are the banks now going to experience the same interest margin squeeze that occurred when former Federal Reserve Chairman Greenspan lowered the Fed Funds rate to 1%? The banks concurred with the analysts that there is floor in deposit rates, even as the prime rate keeps falling.

The squeeze could be much worse today. In the Greenspan era, banks could easily arbitrage between commercial paper and deposits. Much of the time commercial paper (wholesale funding) was a better deal. Today, even with the Fed’s numerous facilities, commercial paper is expensive and difficult to sell. The Wall Street Journal “Federal Reserve Starts Lending Plan” quotes the Fed asking 2.88% for 3 month highly rated commercial paper and 3.88% for asset backed commercial paper. The Fed will reset commercial paper rates daily, and wants the rates to be punitive.

Again the Paulson-Bernanke team is sending mixed messages: Is this emergency financing and a sign of weakness for participating companies, or a sign of strength for the companies allowed to participate? Are they picking winners and losers or simply trying to liquefy the commercial paper market? Do they even know what their objectives are?

Today’s mantra is core deposits are king. And the Treasury is gifting large deposit pools of “weaker” banks to their chosen winners. But even the winners are stuck in the margin squeeze. The prime rate is 4.5% and most banks are offering 3% to 4% on certificates of deposit (CD) up to one year. Rates are in the 5% range for multiyear CDs. Not wanting to be caught short, even the megabanks are paying a premium for committed deposits. The competition for deposits is intense.

If Bernanke lowers the Fed Funds rate to 1%, the corresponding prime rate would be 4%. That would make the prime almost the same as the cost of funds. That would make the prime rate as well as the Fed Funds rates meaningless. Even the best bank customers will be paying prime plus.

Surely Bernanke understands lowering the Fed Funds any more at this point causes the banks more harm than good. Banks profit from a steeper yield curve. Pushing down the long end with the short end fixed is of no benefit. Besides, treasuries are trading well below Fed Funds anyway. Is the stock market psychological benefit of 1% Fed Funds worth the added pain to financial institutions?

Source: Will Banks Again Face a Greenspan-Like Squeeze?