Low interest rates, long viewed as rocket fuel for bank stocks, could ultimately hurt earnings and stock prices, one industry analyst cautions.

"Midsize and smaller banks in the United States could be facing a difficult two years from an earnings standpoint," since rates are likely to fall further, said Richard X. Bove of Raymond James & Associates Inc., St. Petersburg, Fla.

Conventional investor wisdom holds that banks are hurt by higher rates. Mr. Bove and many other analysts dispute that, but investors still tend to sell bank stocks whenever yields on Treasury securities rise, assuming damage to bank earnings.

And in extreme cases, this is true. When the Federal Reserve doubled interest rates in 1994 and 1995, bank profits were chilled, and their stocks caught cold.

Since then, rates have fallen back significantly, and banks have enjoyed some of their strongest earnings ever. The lower-rate environment has fueled bank stocks' dramatic rise.

"It is a very good environment for banks. We have a strong economy, low inflation, and healthy margins," said Sung Won Sohn, chief economist at Norwest Corp. "Banks suffered in 1994 and 1995. The asset quality was good, but the margins were shrinking."

Nevertheless, Mr. Bove, anticipating even lower rates and perhaps deflation because of the Asian financial crisis, has been steadily paring back his banking recommendations since last fall.

His reasoning is concise: Since 1970, bank earnings have fallen in every year that the federal funds rate has declined. The funds rate, controlled by the Fed, is the overnight rate for loans of reserves between banks.

And if lower rates once clearly helped bank earnings, they are a less positive factor now, he said, since banks themselves are so different.

Banks' balance sheets, once laden with fixed-rate products, now abound with variable-rate products whose yields decline in low-interest-rate environments. At the same time, 60% of a typical bank's funding costs remain relatively rate-insensitive, added Mr. Bove.

"When rates come down, margins are squeezed," Mr. Bove wrote. "This should not be surprising."

Moreover, mortgages are a significant chunk of banks' balance sheets. Yields in this sector suffer because homeowners are increasingly quick to refinance, he said.

Meanwhile, midsize and smaller banks also are less able to compete with the lower rates large banks can offer. Big banks can offset lower loan prices by creative funding techniques, including offshore activities, said Mr. Bove. Small banks more typically borrow domestically from consumers.

Though many investors continue to fret that the Fed may boost rates this year, Mr. Bove stressed that chances of an increase are remote. Lower rates are far more probable.

For instance, the Fed recently bought yen to prop up Japan's currency and help reenergize its sagging economy. But it could gain the same objective by cutting rates.

And if the U.S. economy begins slowing, against the backdrop of falling commodity prices and a federal budget surplus, the Fed may do just that, he added.

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