Low Rates Boost Bank Performance, but Fed Governor Encourages Longer View
Since the end of 2000, the Federal Reserve has reduced the federal funds target rate 13 times, dropping the rate to 1 percent as of June 2003. The federal funds rate the rate banks charge each other for loaned bank reserves is a key factor determining banks minimum cost of obtaining funds. If the federal funds rate is low, banks tend to lower the interest rates they charge customers.
The lower interest rates over the past two years have helped consumers purchase or refinance homes and have helped businesses restructure debt. But some industries, including banking, have been obliged to look at their businesses differently because of the historically low rates.
Banks have not been hurting, though the banking industry as a whole posted record profits in 2002. The challenge instead, according to Federal Reserve Governor Mark Olson in a June speech, has been for banks to balance the opportunities of the present with the prospects for the future.
Different types of profits
Spurred by a slow economy and falling interest rates, banks in recent years have experienced substantial growth notably the remarkable and sustained growth in money market deposit accounts (MMDA) and savings accounts and a significant increase in mortgage loans and pass-through securities.
But as low interest rates have persisted, the key rate of revenue generation for banks the net interest margin ? has come under considerable downward pressure. According to Olson, the source of the margin compression can be traced to two primary influences: the self-imposed restraints in pricing MMDA and savings deposits and movement in the spread between residential mortgage assets and these deposits.
Looking toward the future
With much of the asset growth for banks being funded by core deposits, it would be natural to assume that MMDA and savings accounts will continue to demonstrate the same stability as in past years, Olson said. However, he noted that past experience indicates depositors behavior can change significantly as interest rates change.
For instance, if rates return to levels of prior years, banks that rely on the savings accounts and MMDAs to fund long-term assets may be wise to consider the possibility of facing unexpected liquidity or interest rate risk pressures if depositors choose to shift deposit funds to other investment vehicles, according to Olson.
He encouraged banks not to let the opportunities presented to them in the past few years slip away. Through judicious management, banks may be able to retain some portion of these gains beyond this period of low interest rates, Olson concluded.
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