The Federal Reserve's 25-basis-point rate hikes Wednesday, coupled with its announcement expressing concern over inflation, did nothing to calm investor jitters over bank stocks. The Federal Open Market Committee raised the federal funds rate - the overnight loan rate between banks - to 5.75%. The Board of Governors also approved a 25-basis-point increase in the discount rate, which the Fed charges banks for loans, to 5.25%.
"Over time, increases in demand will continue to exceed the growth in potential supply, even after taking account of the pronounced rise in productivity growth," the committee said in its press release. Sung Won Sohn, senior vice president and chief economist at Wells Fargo & Co., said, "Now the Fed is on record as saying that inflation is more of a concern than economic growth. This paves the way for additional hikes in interest rates."
Bank stocks as a group seesawed on the news, with their prices already having factored in Wednesday's Fed move. The American Banker index of the top 225 U.S. banks finished down 1.5%, at 653.1 - slightly lower than when the news came out at 2:14 p.m.
Almost all bank stocks were down for the day, though Firstar Corp. - the subject of a positive report by Merrill Lynch & Co. - rose 31.25 cents, to $24.625. Firstar is one of very few banking companies seen as well hedged against rate risk.
Though a strong economy is good news for banks because it fuels loan growth and fee-based businesses, the three rate hikes since June had already prompted some Wall Street analysts to slash earnings estimates for this year.
Many banks' and thrifts' interest rate margins have been squeezed because rising short-term rates drive up the costs of funds they use to support loan growth. Most banking companies reported tighter margins in the fourth quarter. Loans had grown nicely, but many banks got caught in a bind. Their deposits were not growing as fast because investors have been plowing their savings into the ebullient stock market.
Under the threat of more rate hikes to come, many banks will see more narrowing of their margins, said Warren Heller, director of research at Veribanc Inc., a bank-rating firm in Wakefield, Mass. But the Fed's actions will also force out marginal borrowers, putting a brake on an economy that had 5.8% annualized growth in gross domestic product in the fourth quarter.
"That is what the Fed has in mind," Mr. Heller said. "Putting the squeeze on lenders and borrowers is what it is all about."
A more fundamental concern is how rising rates will affect banks' credit quality. Though they have been hit with some rises in bad loans, the rises in rates so far have had little effect, said David Ellison, a portfolio fund manager at FBR Fund Advisors in Boston. The question is how much breathing room the Fed has to raise rates if needed.
"Rising rates have not had much of an impact yet," Mr. Ellison said. But "how high do rates have to go before people start complaining about it?"
More threatening to banks than the Fed moves could be a stock market correction, said Stephen Berman, a buy-side analyst at Stein Roe & Farnham Inc. in New York. A correction could dampen the so-called wealth effect created by stock market gains. That would eventually undermine consumer confidence, with a ripple effect driving up bad loans at banks.
But even modest increases in nonperforming loans will cut into bank earnings, said Michael Mayo, an analyst at Credit Suisse First Boston.
"The likely interest margin pressure in traditional banking leaves less margin for error for credit quality problems," Mr. Mayo said.