HEARD ON THE STREET
JANUARY 26, 2012, 3:21 P.M. ET
Banks' Zero-Tolerance Tested by Fed
By DAVID REILLY
Just wait until rates rise. That has been the refrain for some time from a host of financial firms groaning under the weight of zero interest rates. Now, with the Federal Reserve saying rates may stay near zero until late 2014, those firms look like Linus waiting in vain for the Great Pumpkin.
And there is a cost to this so-far-fruitless vigil. The Fed's zero-interest-rate policy, which began in December 2008, coupled with its extraordinary moves to bring down long-term rates, have pressured profits at big banks. Meanwhile, insurers, pension funds, assets managers and others are seeing investment returns and income crimped.
Of course, dealing with interest-rate cycles is part of the financial business. But this time is quite different. If the Fed finally raises rates by late 2014, its zero-rate policy will have lasted six years.
That raises fears that financial firms are facing a structural change in the rate environment, despite the Fed's projection that short-term rates should one day bounce back to around 4%. This could lead to further cost cutting and shedding of some business lines, even as financial firms grapple with upheaval caused by the changing regulatory landscape.
There is the additional risk that the Fed's outlook could be flawed and that it has to raise rates earlier than expected. In that case, finance executives who make changes based on the Fed could actually end up wrong-footed by the central bank.
A prolonged period of ultralow rates hurt because asset returns fall but, over time, firms get less benefit from lower funding costs—deposit rates generally don't fall below zero. One clue to the cost comes from estimates banks provide on the potential impact of a sudden change in rates. In the third quarter, for example, J.P. Morgan Chase said that a one percentage point rise in all interest rates would boost pretax earnings over a 12-month period by about $2.5 billion. A rate move twice that size would result in a benefit of $4.5 billion.
Even if only long rates moved by one percentage point, while short-term ones stayed unchanged, the bank said there would be a gain of $576 million. Bank of America tells a similar tale. It said a one-percentage-point increase in rates would boost interest income by $1.4 billion.
The reason behind such gains: Banks are often able to increase the price of loans faster than they have to increase their cost of funding for, say, deposits. They are also able to roll maturing investments into higher-yielding instruments. And rising rates usually come with stronger economic growth, which leads to more lending and less bad debts.
Granted, net interest margins for banks with more than $1 billion in assets, at 3.47% at the end of the third quarter, are in line with the long-term historical average. Also, the difference, or spread, between two-year and 10-year government debt is above long-term averages.
Yet the biggest banks face a tougher time. BofA's margin in the third quarter, for example, was 2.45%. This is largely because they have a higher proportion of assets in investments, as opposed to loans, than smaller banks.
These are often of shorter-than-usual durations due to uncertainties over the rate, economic and market outlook. And that is painful: The spread between three-month and three-year government debt is about 0.34 percentage point, a third of its long-term average.
Speaking on his firm's earnings call this month, BofA finance chief Bruce Thompson said the only things that will cause net interest income to rise "are primarily a change in interest rates, and to the extent that we see a meaningful change in loan demand."
Bank investors should hold on to their comfort blankets: They face a long, cold wait for the gains that will come from any upturn in rates.
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