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It's no secret that the financial sector has been lagging badly, for instance while the Nasdaq (NASDAQ:QQQ) is reaching 12-year highs and the S&P500 (NYSEARCA:SPY) flirts with post-2009 highs, the Financial Select Sector SPDR (NYSEARCA:XLF) is still languishing around 14% below post-2009 highs.

What makes for such a lousy performance, especially when we know that debt delinquency is already waning from the Great Recession levels?

To understand the reason, one needs to know what lies at the core of the banking business. Central to the banking activity, is taking deposits and investing them by making loans and then both paying interest on those deposits, and receiving interest from the loans that were made. Thus the key to making money in the banking business is the difference between the interest received, and the interest paid. This is known as the net interest margin. The next chart shows how the net interest margin has been behaving through time (source: St.Louis Fed):

As we can clearly see, there's a long term downtrend happening here. But it doesn't tell the whole story. The net interest margin relates to the average earning assets, and as we all know, debt spent the last 30-something years exploding upwards, so the average earning assets were higher and higher compensating for the lower margins (ignore the jump back in 2009/2010 - that was the result of bringing into the balance sheets the high-interest credit card securitizations, a technicality).

In this way, while volume grew the margins could contract and still produce a higher amount in terms of total dollars. Unfortunately, after the 2008 credit bubble and crash, most of society (except the government) entered into a deleveraging process. This meant lower volumes, while at the same time the Federal Reserve through ZIRP and successive quantitative easing programs and now operation twist (buying long term securities, selling short term) made sure that the short term rates were zero, and the difference between short term rates and long term rates stayed low, further crimping any possibility of net interest margin expansion.

Worse still, a low rate policy is itself very bad for the net interest margin because some of the deposits (checking accounts) pay little to no interest, so while interest on loans is lowered by a low rate policy, interest on some of the banks' liabilities is not, making for a lower net interest margin. What this all means, is that while the low interest policy remains in place, there's little likelihood for net interest margin expansion in the banking sector, which makes for a lower chance of higher profits.

Conclusion

An end to the low interest policy, together with an acceleration of lending, would be more positive for the banking sector than the current policy of keeping rates low, presently enshrined in the Fed's promise of not raising rates until 2014. If such promise disappears, it might make sense to buy any negative reaction in the financial sector (a negative reaction can temporarily happen because such action would be seen as a tightening of monetary policy).

Source: The Banking Sector Albatross