Yield curve can’t drive profits if banks won’t lend

January 11, 2010

A steep yield curve should mean fat profits for banks. It hasn’t.

Unable to find qualified borrowers and worried that interest rates have nowhere to go but up, banks are stockpiling cash and securities while letting loans dwindle. It turns out banks won’t lend till rates rise. The trouble is, if rates rise their capital will take another hit, leaving them little to support new lending.

The yield curve is a proxy for the difference between short-term rates at which banks borrow and long-term rates at which they lend. In theory, a “steeper” curve means a wider profit margin.

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)


Why not? One issue is that banks aren’t lending. You can’t make money borrowing short if you’re not willing to lend long. Indeed, banks are shrinking their loan books while socking away cash:

(Click here to enlarge chart in new window)


Why do this?

Cash is more liquid than loans, of course, so higher balances protect banks from the volatility of credit markets. Also, it prepares them for stricter liquidity requirements coming from regulators.

The fall in lending is more controversial, but banks are absolutely right to be curtailing loans. One reason, 10% unemployment means a dearth of credit-worthy borrowers. Another important one: 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, by selling CDs for instance. One year CDs average 1.6% according to Bankrate. Because rates can’t go lower, deposits are likely to get more expensive over the 30-year life of the mortgage. What looks like a healthy interest rate spread today (5.3% – 1.6% = 3.7%) is going to tighten.

The risk involved in originating new mortgages is a big reason the vast majority are now purchased or backed by Fannie, Freddie or FHA.

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, limiting profit potential.*

When will banks lend again? Miller argues that “for any meaningful margin expansion…the Fed needs to raise rates.”

The yield curve may be steep, but 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%. To make money, banks need to lend at higher rates.

Also many carry floating assets – credit card and corporate loans, ARMs – that key off indices like LIBOR. A Fed hike would instantly improve their yield.

Trouble is higher rates mean lower real estate prices and higher default rates, which will continue to bleed bank capital. It’s a troubling paradox: Banks can’t make money on new lending without higher rates, but higher rates will increase credit losses on old legacy loans. It’s another reason the Fed is stuck.


*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.

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I actually think it is 180 degrees opposite. The steep yield curve IS the reason banks aren’t lending.

The quote listed “Instead of loans, banks have been plowing assets into more liquid securities according to Paul Miller of FBR Research” is accurate.

Why would a bank lend to a “risky” borrower when they can throw their cash in a 2 year Treasury note with a 100 bps higher yield then their cost of capital (i.e. 0%)? Add in a spread on high quality credit and they are printing money without taking on hardly any risk.

Posted by Jake | Report as abusive

Banks can lend at any rate they wish, no? If they fear the fed will raise rates shouldn’t that be priced in already?

Posted by Jeremy Leipzig | Report as abusive

Jake….buying a two year bond wouldn’t be very profitable. They only yield 0.94% presently. Term deposits already cost more than that. The only thing that costs a bank less, seems to me, is its checking accounts. But these are expensive to service and typically not very large.

The 10-year yields 3.82%. You can buy those with term deposits costing 1.6% and make a nice yield spread. But there’s a bit more interest rate risk with the 10-year. And in any case, that spread isn’t very good compared to the 320 bps banks are averaging…

Posted by Rolfe Winkler | Report as abusive

I should emphasize: their cost of capital IS NOT zero. That’s a popular misconception. Banks fund themselves with deposits and, to a lesser extent, debt. Neither of which can be had for anything close to 0%.

Posted by Rolfe Winkler | Report as abusive

Wouldn’t their marginal cost of funds be what is relevent for making the marginal loan? As such, wouldn’t that be the Fed Funds rate and/or costs of deposits?

Why are the cost of deposits so high? I understand fixed costs, but they can’t add more than 2% to the yield of my savings account.

Posted by Jake | Report as abusive

Jake….banks fund assets with deposits, debt and equity….not fed funds. The cost of deposits is well above the Fed funds rate.

The marginal cost argument doesn’t really work. If I originate a 30 year mortgage and hold it on my balance sheet in order to capture the spread, I have to consider what it will cost to fund that mortgage over its 30 year life. The cost of deposits can’t go lower, so it has to go higher, compressing the spread on the mortgage.

Would you lend to someone today at 5% for 30 years? Probably not. If a bank had guaranteed access to 1% money over 30 years, then it would be more inclined to make the loan. But it doesn’t.

Posted by Rolfe Winkler | Report as abusive

[…] Very interesting article, sums up the current position of the US Banking Industry. Banks seem to be in a lose lose position. Check it out: http://blogs.reuters.com/rolfe-winkler/2 010/01/11/yield-curve-cant-drive-profits -if-banks-wont-lend/… […]

Posted by NYNerd » Blog Archive » Our Banking Paradox | Report as abusive

[…] Source […]

Posted by A steep yield curve is supposed to make for fat bank profits, but not if banks don’t lend. Trouble is, they can’t. Rates have nowhere to go but up. When they do, we’ll just have a re-run of fall ‘08… « Economics Info | Report as abusive

Nice dialogue, but I’m with Jake on this. Moreover, I think there is a closer link between banks’ ST borrowing and ST lending rates than there is between ST borrowing and LT lending rates. Moreover, as LT rates go up, banks are not bound to keep 30-yr loans at 5% or any other low rate. Loan duration mismatches are a huge source of risk under any interest rate situation.

Posted by Lilguy | Report as abusive

Rolfe- I understand your point for a mortgages if you think the yield curve is not steep enough (at the long-end) to compensate.

But, what about the argument that they are using their marginal cost of financing (Fed Funds – they can borrow from other banks at that rate) to invest in short-term liquid Treasuries if they think the Fed was on hold (or unlikely to raise rates much) over that time frame.

Thanks for the prompt responses and keep up the great work on the blog.

Posted by Jake | Report as abusive

I think you are missing the whole point and using the wrong examples. Very few banks are using their own money for mortgages. They are ALL being sold to Fannie & Freddie and therefore being extremely careful in issuing those loans. The bank lending on everything else is a function of the collateral the loan is against. So, we have company account receivables from other companies under duress. Commercial real estate that is continuing to decline in value, residential real estate which contrary to media fantasy will continue to decline (option arm loans). What are you going to lend against? What is the risk? Will you risk your job to lend against these declining assets?
btw, there is no market for mortgages beyond Fannie & Freddie at this time……………..

Posted by Doug | Report as abusive

I would agree with the article to a certain extent. But have you considered why banks won’t lend? They only lend if they are confident of the market. Which banks on earth do not want to make money? There is one fundamental element missing in the discussion, that of Risk or Beta. Only with a manageable beta versus profit will the bank starts lending.

Posted by Lim Boon Chuan | Report as abusive

Banks are hedge funds now. Do hedge funds loan money?

Posted by Mark | Report as abusive

[…] Steep yield curve = bank profits. […]

Posted by FT Alphaville » Further reading | Report as abusive

While the argument here has merits for retail banks I don’t think the same is true for investment banks. I have a suspicion that the steep yield curve is the result of banks making a profit from fixed income investments rather than the other way round. What is missing from the argument is that other sovereign debt rates are not the same as US ones. There is money to be made borrowing in US dollars and investing in Australian sovereign debt especially with currency fluctuations. At the same time US banks need to have some liquidity so they continue to buy into the short end of the curve in the US. Even for retail banks clever hedging and arbitrage between treasury and agency debt can give some profits. Since investment banks did make a lot of money over the last six months from fixed investment even before the yield curve began to steepen then your argument that the yield curve is not responsible seems to hold water. I have a suspicion though that investment banks have an interest in keeping the yield curve steep for the foreseeable future to help keep their profits up.

Posted by Brick | Report as abusive

[…] Yield curve can’t drive profits if banks won’t lend Rolfe Winkler […]

Posted by Links 1/12/10 « naked capitalism | Report as abusive

isn’t it to do with time horizons? right now bankers have incredibly short time horizons (even by their standards). nobody is thinking beyond the current bonus round. everybody is worried about the growing political backlash against bankers. everybody is still afraid that the current market rally is liquidity-driven and unsustainable. and nobody knows what the long-term “normal” is any more.

in this context, why would anyone choose to extend a 30 year loan, if it means (a) taking a 30-year view where even the 30-year outlook is very binary (considering e.g. japan the last 20 years), and (b) you can only accrue the profit whereas bankers want to show profits and get paid bonuses now (as it may be their last chance for a long time).

better far to buy into the latest bubble, and hope you get your paycheck before it bursts.

Posted by bena gyerek | Report as abusive

Any sale requires a willing buyer. The banks are not lending because borrowers are not borrowing. What rational businessman is going to increase his indebtedness in today’s economy, wherein the whim of any stray bureaucrat stands poised to wipe him out at any stray moment?

Posted by G. Kincaid | Report as abusive

If you believe yields are going higher, you must limit your duration. Unless banks are going to have their long term loan portfolios forever priced at par value instead of market value, they must take into consideration the hit on capital they will receive if interest rates start to spiral higher.

On the other end of the equation, companies aren’t requesting new debt at the same levels as before. Until the economy proves it has turned itself around without requiring government stimulus, companies and people are going to limit their debt loads.

Posted by Steve Roberts | Report as abusive

Do american banks have no interest rate management or treasury? The question should be: What’s the margin after hedging away the interest rate risk. Could it be that Fannie & Freddy are ruining the prices?

Posted by Alexander Groschke | Report as abusive

[…] The Fed is stuck.  (Rolfe Winkler) […]

Posted by Tuesday links: short suffering Abnormal Returns | Report as abusive

Great article and posts. One thing I noticed is an SBIC who said they will only loan to a “small” business with $10M or more in revenue. It probably is the reason the banks won’t loan is the government programs are so convoluted and hijacked they can’t loan to the people who need it. I think 52% of Americans work for truly small business but the government actually has no real programs for them. Only token programs. Its like the rich people cruising on their yacht past a hovel and saying “Someone ought to help those poor wretched chidren”. And another one says, “Yep, someone really ought to help them”. Then they get back to how they can help each other to the taxpayer loot. That’s EXACTLY how the US government works.

Posted by MaxWeber | Report as abusive

Jake is 100% dead right and i see there is alot of ignorance on how banks work …… take a look at companies like NLY and ANH and CMO . Look at those 15-18% dividends they actually are earnings . All they do is buy FNMA and Freddie Mac mbs bonds that can be levered at 20×1 in the repo markets ( these guys levering at just 5-6×1 ) and you can hedge the interest rate risk with swaps and earn almost 20% on your capital .

Did any of catch the claims by the Fed they earned record profits in 2009 doing exact same thing ? and keep in mind , buying hundreds of billions in GSE mbs has full faith and credit of US government now vs the risk of lending to companies or peeople .

you can fund yourself in repo markets at like 1/2 of 1% for 6-9 months now …… FNM mbs bonds yield 4.5% ….. thats 4% spread differential …. lever that up by 5 x 1 ( modest leverage when you consider NLY used to run at 12-13×1 in the past when spreads were tighter ) and its 20% with no credit risk .

JPM and GS and others are putting on same trade in huge size . You guys focusing on CD costs as what banks pay are ‘ out to lunch ‘ and think its how banks operated when you were in grade school .

Posted by bob connors | Report as abusive

With the prospect of inevitably higher rates and possibly inflation as well I’m not surprised at all that banks don’t want to lend and that any such loans would be unprofitable. Nevertheless, in my own experience banks are lending – but only to credit worthy borrowers. So what. That’s good.

I don’t claim to know much about banking – and so don’t know if this is even possible – but I do wonder if the banks’ reserve money were used to buy equities and Treasuries last year (hence being the so-called “household sector” identified in the Fed’s own flow of funds report, that mysteriously came to the rescue for the Fed and Treasury.)

Posted by Bruce Calder | Report as abusive

This is a very good piece from Rolfe.

I would add two things:

1. Credit demand is the real problem, as U.S. households have simply run out of income to service more debt: their income is flat in ten years while their debt was rising. We have reached the point of saturation, with sub-prime being the warning signal that we were actually beyond the threshold already.

2. The banks build up coffers of cash because they know what kind of waste they still have on their books. And as soon as anything happens, up or down, they will be in trouble again. They try to get out of this through trading, speculating while enjoying the too-big-to-fail get-out-of-jail card the government has given them by guaranteeing all losses and all loan books.

The banks seem to think that this will go on for a while, because they give about 40% of their profits away in bonuses instead of replenishing their equity.

Conclusion: the big banks must be broken up, and no bank can capture more than 1% of savings in the future, in order to ensure healthy and proper competition.

Posted by Ronald B | Report as abusive

[…] би означавало невероятна възможност за банките да реализират печалби, защото ниските краткосрочни лихви са индикатор за […]

Posted by Липса на доверие на прага на очакваното икономическо възстановяване | Forex | Форекс | Report as abusive

[…] curve to make banks lend to something other than the US Treasury is predicated on there actually being some private sector demand for loans (something which is still totally unclear), of course. But it might put a stop to some of […]

Posted by FT Alphaville » Unwinding the US Treasury trade | Report as abusive

[…] curve to make banks lend to something other than the US Treasury is predicated on there actually being some private sector demand for loans (something which is still totally unclear), of course. But it might put a stop to some of […]

Posted by BUND, TBOND and the middle of the guado (VM 69) – Pagina 926 – I Forum di Investireoggi | Report as abusive

[…] you unprepared for when something does happen. My comment about bank margins was based on this: Rolfe Winkler | Analysis & Opinion | Reuters.com If credit becomes more readily available and the economy gets back on its feet, we're going to see […]

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