The Fed, Banks, and Why Easy Money Can Make It Difficult for Lending

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In its April statement, the U.S. Federal Reserve clearly said it would continue to keep the federal funds rate near zero percent until labor markets improve and economic growth becomes sustainable. In the same month, Bank of America (NYSE:BAC) reported that its net interest margins shrank to its lowest in more than a decade in the first-quarter this year.

So, how are the two facts related?

The federal funds rate — or the rate at which banks borrow from the Federal Reserve on an overnight basis to manage its asset liability imbalances — has been near zero percent since the financial crisis. The reason the Fed continues to keep these key interest rates so low is to make sure high interest rates do not stifle businesses growth and investment that are key drivers of economic activity and job growth.

The interest rates charged by banks on loans and deposits are anchored to the federal funds rate. Banks make money on the difference between what it pays depositors and the interest it charges from borrowers. This difference is called the net interest margin (NIM), or broadly the net interest yield. When interest rates are lowered, NIMs tend to shrink since banks are capped from charging a very high interest rate. The interest rate targeted by the Fed serves as an indicative rate for the markets.

A yield curve, which is a combination of interest rates charged for assets with varying maturities (going from shortest to the longest), is important to how interest rates impact bank profits. A steep yield curve is what banks are looking for. Since deposits are of a short-term nature, its pricing is linked to the market price of short-term assets, like say the three month treasury bills. Loans are generally long-term, so its pricing is influenced by the yield on longer term assets. In what is called the time value of money, lenders must be rewarded for holding on to the risk of having lent for longer term. So a steep difference in the interest rates on short-term and long-term assets makes for a steep yield curve, which means more profit margins or NIMs for banks.