Add another challenge to bankers' already lengthy list.
When the Federal Reserve Board raised the discount rate 25 basis points last week, most everyone was quick to say that discount-window lending had been relatively light lately and the short-term impact would be minimal.
But long term, the move could foreshadow broader changes that may squeeze lenders' already tight margins, raise deposit-gathering costs and discourage lending when the political pressure to rev it up is high.
Scott Siefers, an analyst with Sandler O'Neill & Partners LP, said the increase indicates that the Fed is moving closer to raising the more-important federal funds rate.
Raising that rate could actually hurt banks' margins because so many of the industry's business loans have hit the so-called floor, or the minimal rate a lender and borrower agree to when negotiating a commercial mortgage or property loan, he said.
Floors have become more prevalent because banks through the downturn have been doing everything they can to help borrowers stay solvent. A simple way to do that is to grant them more generous loan terms. They have also relied on floors to avoid having to lend out money so cheaply that they can't turn a profit.
The problem is lenders can't raise a loan rate until the prime rate puts a borrower's interest rate above the minimum interest rate that both parties agreed to. Siefers says some banks' margins could suffer if their floor rate is much higher than the current prime rate of 3.25%.
That's because a rising prime rate could upset the industry's bread-and-butter business of lending out money at a higher rate than it borrows from depositors. Deposit rates move in conjunction with interest rates. Loan rates — particularly on commercial loans — could stay static until the prime rate hits the proverbial floor, he said.
"Lending rates might not all move up because there are a lot of floors in place," he said. "Margins could get squeezed."
Bankers interviewed for this story insisted they are prepared, but whether they are the exception or the rule remains to be seen.
W. Swope Montgomery Jr., chief executive of BNC Bancorp in Thomasville, N.C., said his $1.63 billion-asset company has been careful to watch its commercial loan floors in anticipation of an inevitable interest rate hike.
Most of its commercial borrowers are at a floor rate of 5% to 6% right now. The bulk of those loans are priced at prime plus a half or prime plus one. So they'd be paying a rate of 3.75% to 4.25% if the floor wasn't there. He said his company is comfortable that its loans aren't too far below the floor in the event of an interest rate change.
His company has also been taking steps to protect its funding costs when rates change. In the last six months, it has been trying to lock in funding rates by extending maturities on wholesale borrowings to three to five years from one month to three months.
Tim Carter, president and CEO of OmniAmerican Bancorp Inc. in Fort Worth, Texas, said his company is betting that key rates start rising in the fourth quarter.
Most of the $1.13 billion-asset company's business loans are rated prime plus one or prime plus two, which ensures that they aren't drastically under its typical 5.5% to 6% loan floor, he said.
He said the company "feels good" about the positions of its assets and liabilities, and is not concerned that its loan floors could hamper its ability to raise rates. When interest rates rise, they'll probably go up gradually, he said. That's better than a swift increase that could stress borrowers.
When "the re-pricing on your asset side is slower on the re-pricing on your liability side - that is where banks have to be careful not to be squeezed," he said.
Michael Fitzpatrick, chief financial officer of OceanFirst Financial Corp., said the Toms River, N.J. lender has been trying to grow core deposits, which tend to be more interest-rate resistant than other liabilities. It has extended maturities on products like certificates of deposits, locking in rates in a favorable funding environment to avoid having to re-price them when the good times come to an end.
There are other consequences to rate increases, too.
Tim Yeager, a finance professor at the University of Arkansas and a former economist with the St. Louis Fed, said he believes the Fed's next step could involve raising interest rates for the more than $900 billion in reserves that banking companies have parked at the central bank. The Fed began paying rates on reserves in October 2008 as a way of controlling credit growth, he said.
"Too much credit sparks inflation," Yeager said. The Fed must balance concerns about inflation with an initiative that could discourage already anemic lending. "It is analogous to paying farmers to not grow crops," he added. "You are paying banks not to lend."