Banks make money in many ways, but one important way is by borrowing it and then lending it. Borrowing it at a lower interest rate, lending it out at a higher rate and profiting from the difference between the rates is known as the spread.
For a period of time going on three years, though, it has been very difficult for banks to make money by lending because the differential between short-and long-term interest rates is very small. Experts call that the flattening of the yield curve. The curve is supposed to represent the increase in rates that takes place when money is borrowed over a longer period of time. With short-term rates at zero to a quarter percent and long-term rates at 2 percent, there isn”™t much of a spread from which banks can profit. As for when this situation may change, analysts say that”™s anybody”™s guess.
“It”™s terrible for banks to have to operate with interest rates being as low as they are,” said Gerard Cassidy, managing director at RBC Capital Markets in Portland, Maine. “The moment rates start to go higher, the banking industry is set to increase its profitability dramatically.”
Jeffery Harte of Sandler O”™Neill in Chicago said the industry was getting help for a while from the decline in short-term rates, but they can”™t go any lower now.
“What we had seen for a while was funding costs decline to offset the revenue impact of lower long-term interest rates. But we”™d be hard pressed now to have funding costs go down. We are
seeing long-term rates pop up every once in a while. We may be nearing the end of the pain. We are starting to see some loan growth.”
Cassidy said he sees some evidence of that loan growth in the banking industry”™s first-quarter earnings reports.
“Banks are lending; numbers from the Fed bear this out. But today when they lend they expect it to be paid back; they”™re not making bad loans anymore. The standards are more conservative than in the depths of the recession in ”™08 and ”™09, but there are still many customers that qualify. People are borrowing. The corporate area is very strong.”
Given the narrow spread, he said banks are finding other ways to make money. “Now the earnings of the largest banks have been better than expected, the reason is that they”™re seeing revenue growth from nontraditional banking business, the capital markets business, and even growth in mortgage lending. It”™s refinancing activity from some of the government programs designed to allow people to refinance their underwater mortgages.”
Cassidy said banks are getting their operating expenses under control and credit quality continues to improve.
Considering the interest rate environment and the state of the economy, Brad Hintz of Sanford C. Bernstein said earnings are looking good so far.
“We have an economy that”™s still picking up, but the credit side (of the banking business) is looking okay, trading businesses have performed quite well. But Schwab investors (the small investor) are still pretty timid. Only now are they looking out of the foxhole and asking if it”™s safe to come out. There”™s a real caution.”
Hintz said that cautiousness is not limited to the small investor, though. “M and A (merger and acquisition activity) is dormant, and in slow times executives typically look toward deals as a way to grow. There”™s caution on the part of the retail investor and CEOs of big companies.”
Harte agreed.
“M and A activity requires CEO confidence. We”™ve had such volatility in economic numbers and the markets for such a long time, they”™re exceptionally cautious now. It”™s a very unique time with volatility and difficulty in predicting that volatility. As long as we can go without volatility, there are a lot of transactions in the pipeline, it”™s a matter of confidence.”
