Low Rates are Squeezing Bank Profits

The Federal Reserve's gift to U.S. banks—low interest rates that have helped boost profits for the past year and a half—has stopped giving. While lenders can still raise money cheaply, they have started to earn less on new loans and investments. As a result, banks including Bank of America (BAC), Citigroup (C), and JPMorgan Chase (JPM) are finding it harder to make money.

To aid the economy, the Fed has been keeping its target rate for overnight loans between banks near zero. That has benefited lenders by providing record low costs of funding mortgages and other loans. "That's the gift from the Fed," says Christopher Whalen, a former Federal Reserve Bank of New York analyst and co-founder of Institutional Risk Analytics. "But at the same time, the cash flow on your assets eventually starts to re-price and match the low-rate environment. The zero-rate environment is eventually bad for everybody."

The effects of the squeeze can be seen in the latest quarterly reports. Net interest margins—the difference between what it costs banks to raise money and what they get for lending and investing it—fell by 26 basis points, to 3.06 percent, at JPMorgan from the first to second quarter; 17 basis points, to 3.15 percent, at Citigroup; and 16 basis points, to 2.77 percent, at Bank of America (BAC), according to company reports. (A basis point is 0.01 percentage point.) The reduced margins contributed to a drop in net interest income of $1.02 billion at JPMorgan, the second-largest U.S. bank by assets. It fell $849 million at Bank of America, the biggest lender, and $522 million at Citigroup, which is third. Wells Fargo (WFC), the fourth-largest bank, reported that net interest margin increased by 11 basis points, to 4.38 percent, in the second quarter, the result of higher-than-expected income from soured mortgage loans.

Bank of America Chief Executive Officer Brian T. Moynihan told analysts on a July 16 call that the "sustained low-rate environment" was hitting revenue and earnings and will continue to affect margins. JPMorgan CEO Jamie Dimon told analysts the day before that the bank's net interest margin will continue "coming down a bit as we reposition the portfolio."

The banks may be coping with the low-rate problem for some time. The Fed has signaled that slowing inflation and a sluggish economy will push any interest rate increase into 2011. In a June 23 policy statement the Fed repeated a pledge to keep the benchmark interest rate near zero "for an extended period." Says Matt O'Connor, an analyst at Deutsche Bank (DB) in New York: "It's a massive issue....Bank of America, Citi, and JPMorgan are feeling the pressure now and will continue to feel pressure for the foreseeable future."

After the Fed brought down short-term interest rates in 2008, banks slashed the rates they offered depositors. The average rate paid on checking accounts was 0.53 percent on July 27, the lowest since February 2005, according to Bankrate.com. Overall, the industry's average cost of funds fell to 1.03 percent in the first quarter of 2010, the lowest on record, according to the Federal Deposit Insurance Corp., down from 3.58 percent in late 2007.

The relatively wide spread between what banks were paying to raise money and what they earned on it helped boost bank profits even as the economy remained weak. JPMorgan's profit on loans and other interest-bearing investments increased to a record $51.2 billion last year after the Fed dropped its target rate to current levels, up 32 percent from 2008 and nearly double the bank's net interest income in 2007, when the Fed's target rate was 5.25 percent.

That lucrative spread narrowed as the Fed kept rates low. The average yield banks earn on their investments and loans has dropped to 4.86 percent from 6.93 percent in late 2007.

Another concern for bank profits is a drop in the volume of lending. Banks have tightened their standards and demand has dropped, according to the Fed's senior lender survey. "There's no loan demand, and long-term rates have declined so much," says Deutsche Bank's O'Connor. "So as you look out over the next few quarters, it's potentially a very dire situation for the overall industry."

Nancy A. Bush, founder of NAB Research, an Annandale (N.J.)-based independent research firm, puts it even more bluntly. "We've hit the floor in deposits, you can't go any lower, and your asset yields are declining," she says. "So there's only one way to go for the margin, and that's down."

The Bottom Line: The low rates that helped banks boost profits are now having the opposite effect as returns on loans and investments come down.

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