Paradoxically, Lower Interest Rates Are a Negative for Banks

With his recent public comments, Federal Reserve Chairman Jerome Powell appears to be telegraphing future cuts to the Fed Funds rate, starting at the upcoming July FOMC meeting. Based on Eurodollar and Fed Funds futures, as well as FactSet estimates, markets are receiving the message and pricing in lower rates.

However, one typical market reaction to the prospect of lower interest rates has been absent. Historically, investors have tended to view rising rates as a negative for banks and declining rates as a positive. Yet while the S&P 500 is near its all-time high, the KBW Nasdaq Bank Index is down nearly 7% over the last 12 months.

Why Aren't Bank Stocks Performing Better?

Typically, a cut to the Fed Funds rate both reduces the cost of banks' raw material—deposits—while boosting demand for their core product—loans. The increased liquidity generated by lower rates also tends to tamp down credit costs, as marginal borrowers find it easier to remain afloat. 

But like many otherwise robust correlations, this one starts to behave differently at the extremes. In today’s low rate environment, a reduction in rates is more likely a headwind for bank earnings. The core of the problem is the zero-bound on interest rates, which means that as lower rates reduce loan pricing, banks have trouble fully offsetting that decline with reduced deposit pricing. Think about it in your capacity as a customer. Your checking account likely pays no interest—as a practical matter it is impossible for that rate to go lower—and if rates on savings accounts and CDs approach zero, you’re apt to start looking around for alternatives.

Another unique aspect of this cycle is the likely secular increase in large, credible online competitors competing for deposits. This increased competition may further constrain banks' ability to pass lower rates on to depositors. Because online banks typically maintain few physical offices, they can attract deposits by paying higher interest rates than their traditional brick-and-mortar competitors. Online banks have been competing for a couple of decades now, but twenty years ago they were companies like NetBank (new) or ING Direct (European), with which most U.S. consumers were unfamiliar. Today competition for online deposits comes from companies like Goldman Sachs and Capital One—large well-known firms with a much stronger claim on depositor confidence. Given the ubiquity of smartphones, the lack of branches is much less of a handicap than in the past.

In the current low rate environment, the pain of managing assets and liabilities may be relatively lighter for banks with high levels of wholesale funding. Wholesale funding is used by banks to augment the funds from retail deposits and can include money market mutual funds, large certificates of deposit, foreign or brokered deposits, and repo funding. Because these funds tend to be less sticky and more expensive than core deposit funding, large amounts are generally considered a negative factor for bank balance sheets. However, wholesale funding may enable banks to reduce funding costs faster and deeper than banks that have what is typically viewed as a higher-quality funding mix. 

Banks with Highest Share of Non-Interest-Bearing Deposits (Mil. $)

Source: FactSet

As shown in the table above, non-interest-bearing deposits represent 22.7% of total deposits for the median large bank holding company. However, at the high end, The Bancorp, Inc. reports 92% of total deposits in non-interest-bearing deposits. As a structural matter this is immensely valuable. On average and over time, it is easier to keep your margins up when you don’t have to pay interest on your deposits. However, with today’s low rates, this enviable funding mix becomes more of a mixed blessing. As lower interest rates pressure yields on the loans and bonds held by banks, a bank that only pays interest on 8% of its deposits will be hard pressed to achieve a commensurate reduction in deposit costs.

The pain isn’t limited to the liability side of the balance sheet either. Just as rising rates pull loan growth forward by incentivizing borrowers to lock in rates before they go higher, the prospect of declining rates incentivizes borrowers to hold off on borrowing until they absolutely must. The longer they wait, the cheaper the loan is likely to be. 

Banks with Lowest Loan-to-Deposit Ratios (Mil. $)

Source: FactSet

Limited Options Available for Banks in Current Low Rate Environment

What could mitigate this earnings pressure and give bank stocks a boost? For banks with low loan-to-deposit ratios, as in the table above, one lever would be to replace some of the securities on their balance sheets with higher-yielding loans. Note that in this table, we exclude banks with ratios below 50% as they are generally involved in some aspect of the securities business and therefore not reflective of the broader industry. Texas-based Cullen/Frost Bankers and Prosperity Bancshares have scarcely half of their deposits funding loans so it wouldn’t require a huge shift in their asset mix to mitigate the impact of declining interest rates.

More broadly, one thing to watch is the rest of the yield curve. If the curve starts to steepen, it will relieve much of the pressure on bank margins. Unfortunately for banks (and their shareholders), the opposite has been happening of late.

Against the backdrop of low rates, we can probably expect to see an uptick in bank M&A activity. Banks that had been struggling to meet profitability and growth hurdles in the post-crisis period finally appeared to have the wind at their backs as the Fed lifted rates off the floor. A reversal in the direction of interest rate movements may cause some managements—possibly encouraged by boards and investors—to pursue (or at least be open to) a sale.

Absent these sorts of countervailing forces, a renewed cycle of Fed loosening is apt to remain a negative for bank earnings.