History’s Lesson for Managing a Bank in a Zero Interest Rate Environment

At its most recent Federal Open Market Committee meeting last month, the Federal Reserve Board reiterated its intention to use the tools at its disposal to manage the money supply and hold its discount rate target between zero and one quarter of one percent. 

The FOMC had already announced that it had begun aggressively purchasing mortgage-backed instruments to help drive down long-term interest rates.  The combined effect, as the FOMC stated in its release, will be to keep interest rates at very low levels at least through 2015. 

These moves may be an appropriate way to stimulate the economy. As a former Federal Reserve Governor and member of the FOMC, I'm fully supportive of the current actions. But they also raise new and potentially difficult management issues for bankers. 

Before considering how bank managers might address these issues, it's instructive to take a look at prior interest rate environments. For most banks, their business models are premised on a yield curve that gradually slopes upward. This implies that interest rates will rise over time, relatively steeply in the early years and then at a slower rate.

This environment tends to serve the banking industry well because in it banks enjoy a significant amount of low-cost, short-term checking and savings deposits on which they either pay no interest or their lowest rates. These funds are then available for short- and medium-term lending.

A rising yield curve assures that banks can lend out these funds while maintaining profit margins. The term "real interest rate" referred to the rate available to an investor after adjusting for inflation. If an investor earned a 6% rate on an investment, and the inflation rate was 3%, for example, the real interest rate was 3%.

Few depositors actually computed their real interest rate returns, but they seemed to intuitively understand the concept. For much of our recent history, bank depositors received roughly 2% to 3% real interest rate returns, and for many years banks expanded deposits through issuance of long-term certificates of deposit. 

Even in a rising interest rate environment, depositors seemed quite comfortable combining the security of FDIC-insured deposits with an interest rate that kept them measurably ahead of inflation. The biggest risks for banks occurred in highly volatile rate environments, when the yield curve would flip or be "negatively sloped" and depositors would avoid longer-term rate commitments in favor of readily available funds.

That rate environment created difficult choices for banks trying to match the rates and terms of assets with a highly volatile deposit base.  In that environment, banks would often experience significant outflows of deposits as savers went in search of higher short-term interest rates.

So what challenges do banks face in today's environment, where inflation is under control and the concept of a real interest rate return is virtually non-existent?  There are two critical issues.  The first involves the temptation bankers face to reach for extra yield.  This can occur in the lending sphere if banks seek out loans with the highest interest rate margins.  By definition, high margins imply high risks, and any benefit from early profits is likely to be offset by soured loans down the road. Banks typically apply a 50 basis point potential reserve on the healthiest loan portfolios; high-risk loan reserves go up from there.

A bank's investment portfolio management can also be affected by the stretch for yield.  Ten-year Treasuries now yield less than 2%. To earn 3% on Treasury instruments, a bank has to go out to 30 years.