'Tis the season to crystal ball the economic outlook.
Economists are dissecting corporate profits, initial jobless claims and retail sales for clues on the direction and strength of the economic recovery for 2011 and beyond. Perhaps they should look closer at the prospects for bank lending and profits. The collapse in bank profits following the asset bubble collapse in residential housing was a major factor in the severity of the Great Recession and remains an important reason why economic growth has remained painfully slow in this recovery.
Under Chairman Ben Bernanke, the Federal Reserve has embarked on another round of quantitative easing and committed to buying at least $600 billion more in U.S. Treasury bonds by June 2011. This isn't necessarily good news for the banking industry.
Beyond forestalling deflationary forces, the Fed's stated goal is to push long-term interest rates lower than they are already. This is meant to bolster lending and spending by consumers and businesses and reduce the time needed to push our unemployment rate down to about 5 percent or6 percent-which most economists see as its natural level.
In order to justify these policy measures, the Fed has pointed to the success of QE1, in which it was able to push down long-term mortgage rates by about a percentage point, and spark a sizable purchase and refinance boom in the mortgage market.
But with its focus on boosting demand for credit, the Fed is ignoring the potential impact of its policies on the supply of credit at a time when lending standards remain tight and the banking industry's financial intermediation function continues to be impaired. At what point do lower mortgage rates and interest rate margins begin to impact the banks' ability to make new loans? The bankers I have talked to are wringing their hands about the Fed's latest policy prescription.
They admit that the demand for new loans is anemic at best, but most don't see the price of credit, or the interest rate, as the largest stumbling block. In the housing market, the numbers of underwater households (those with more mortgage debt then their homes are currently worth) reduce purchase and refinance demand at any and all interest rates.
In the business loan market, excess capacity and record cashflows and profits reduce the need to utilize credit lines or take out new loans to fund expansion. Indeed, the most financially sound consumers and businesses will just take advantage of any interest rate windfall from refinancing at lower rates by paying down their debt that much quicker, hardly a path to bank profitability down the road.
Just as the Cash for Clunkers program and homebuyer tax credit temporarily boosted demand for home and auto purchases, the Fed probably can temporarily boost demand for loans if it buys enough Treasury bonds.
But the downside of this policy is that the banks will be left with loan portfolios bursting at the seams with low-interest-rate loans. The longer the Fed keeps interest rates near zero, the lower the average interest rate on the loan portfolios will go. Looking at the latest bank earnings or the Federal Deposit Insurance Corp.'s Quarterly Banking Profile for the third quarter, one can already see the fingerprints of the low-interest-rate environment on bank revenue growth.
For now, bank earnings have been somewhat sheltered from this trend as banks reduce their loan-loss reserves, but that won't be a long-term panacea for what ails the banking industry.
The pressure on profit margins will intensify when the Fed finally does get around to unwinding its policy of quantitative easing and the banks' cost of funds begin to rise rapidly while loan portfolios continue to languish at low average interest rates.
If elevated credit losses and sluggish loan demand weren't hard enough to contend with, it seems bank executives will soon have another more intractable problem: maintaining profitability when the Fed returns interest rates back to normal. The longer the Fed maintains this ultra-low-rate environment, the more difficult it will be for the banks to return to normal with the economy, and this could keep U.S. economic growth on the disappointing side for years to come.
