It once was a given: Lower interest rates were good for banks. When rates fall, the thinking went, profits grow--since banks pay less for deposits yet still collect interest from existing loans and investments. But in today's noninflationary environment, the conventional wisdom has been turned on its head. In 1999, look for falling rates to be bad for banks.

That's because banks are paying so little for deposits that it's hard to believe they can cut rates much further. Currently, according to Bank Rate Monitor, a standard money-market account pays about 2.3%, while an interest-bearing checking account yields around 1.3%. With the Federal Reserve lowering rates, analysts suspect that banks will see their margins squeezed as deposit rates stay put and returns on loans and bonds fall. And although fees make up an increasing portion of bank income, most profits still come from interest. "Contrary to popular belief, lower and lower short-term interest rates are not good for deposit-funded banks," says David S. Berry, research director at Keefe, Bruyette & Woods Inc. "It's hard to lower deposit rates in concert with the decline in market rates."

BUG-PROOFING. The resulting pressure on profits will be just one more difficulty in what is likely to be a challenging year for banks. The Fed, after all, cut rates because market turmoil was harming many of the businesses that banks have embraced to reduce their reliance on interest income: fee-generating activities such as underwriting and trading. And if the outlook for those businesses isn't enough of a worry, banks will also face a special task: the expensive job of preparing their computers for the Year 2000.

To be sure, there are reasons to be cheerful about banking. For a start, the domestic economy is robust. Moreover, lending standards seem to be tightening following the blowup in the capital markets. Asset quality also remains good--as long as you overlook credit-card charge-off rates rivaling those of the last recession. And lower interest rates should help customers pay back debts and revive capital markets.

But uncertainties abound. J.P. Morgan & Co.'s announcement that its fourth-quarter earnings would fail to meet expectations raises the specter of more bad news from trading desks. "We aren't convinced that all the problems have been fully recognized when it comes to the recent turmoil in the emerging markets," says Michael L. Mayo, bank analyst at Credit Suisse First Boston.

And preparations for 2000 could get hairy. Already, banks are finding that they underestimated testing costs. Still to be determined are the cost of logistics--from running help desks to finding enough trucks to keep ATMs stocked with cash on the big day, says Raymond F. Strecker, vice-president of American Management Systems Inc. of Fairfax, Va. Get ready for an extraordinary year.

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