The Fed Trap: Bank Lending and the Yield Curve

by: Rolfe Winkler, CFA

The steep yield curve isn’t helping banks as much as you’d think. Worried that interest rates have nowhere to go but up, they’re stockpiling cash and securities while letting loans dwindle. It turns out banks won’t lend till rates rise. The trouble is, if rates rise banks may not have capital to support lending.

The steepness of the yield curve is thought to be crucial to bank profitability. It measures the difference between short-term rates at which banks borrow and long-term rates at which they lend. The “steeper” the curve, the wider a bank’s profit margin. At least in theory.

As the following chart shows, bank profit margins aren’t keeping pace with the steepness of the curve.

(Click here to enlarge chart in new window)NIMsClick to enlargeWhy not? Because banks aren’t lending. You can’t make money borrowing short if you’re not willing to lend long. Indeed, banks have let their loan books dwindle while stockpiling cash:

(Click here to enlarge chart in new window)loans-cashClick to enlargeWhy are banks cutting lending while stockpiling cash? Cash is a more liquid asset than a loan, of course. Having more of it means banks have more protection from continued economic uncertainty. For instance, it’s not clear what will happen when (if?) the Fed and Treasury stop supporting credit markets. Cash on the balance sheet will protect them if markets go haywire again. Also, banks are preparing for stricter liquidity requirements likely to be handed down from bank regulators.

The fall in lending is more controversial, but banks are absolutely right to be curtailing loans despite the steepness of the yield curve. That’s because rates have nowhere to go but up.

A bank originating a new 30-year mortgage at 5.3% is taking significant interest rate risk. Remember, the bank has to borrow short to fund the mortgage. Today that means selling a 1.6% one-year CD, for instance. But since rates have nowhere to go but up, one-year CDs are likely to get more expensive for the bank over the 30-year life of the mortgage. What looks like a healthy interest rate spread today (5.3% – 1.6% = 3.7%) is likely to get much tighter over time.

Also as rates climb, there’s a higher risk of default as prices fall and folks walk away from underwater mortgages. Theoretically this risk should be lower for mortgages originated today: Prices have already fallen quite a bit and banks are demanding bigger downpayments. But again, it’s anyone’s guess what could happen in the absence of government support for housing.

Instead of loans, banks have been plowing assets into more liquid securities according to Paul Miller of FBR Research. But as credit markets have healed, the interest rate spread on these assets have also come down, reducing the potential for profit. Last week regulators issued a warning to banks about interest rate risk, their first since 1996. It’s likely the warning stems from regulator concerns over banks’ holdings of securities.

What will it take to get banks to lend again? Paul Miller of FBR Research argues that “for any meaningful margin expansion…the Fed needs to raise rates.” Though the yield curve may be steep, it’s steep at low rates. Banks can’t capture the whole spread because they have to pay significantly more for deposits than the Fed funds rate of 0-0.25%. For banks to make money, they need to be able to lend at higher rates.

This is just another reason the Fed is trapped. Banks won’t lend unless the Fed raises rates, but the Fed can’t raise rates without destabilizing markets and hammering bank capital.