Wednesday, January 6, 2010
Banks, Lending & Why Not
There is a lot of chatter lately about the banks not lending money to creditworthy customers. I am not surprised by this turn of events. But to understand this, one must understand how banks work, or, how they make their money - profits.
For many years banks, now I am talking about commercial banks, not investment banks (they are different) made their money by lending money to creditworthy customers, either commercial or individual. Banks took in deposits in the form of checking accounts or saving accounts. Traditionally, banks paid interest only on savings accounts. Banks then would loan money at an interest rate greater than the interest rate they paid on savings accounts and certificates of deposit. The difference between the interest rate they charged and the interest rate they paid on savings, less their expenses, was known as the spread. Banks collected a few fees every now and then, but their principle source of earnings was the spread.
If banks loaned money for a long duration at a fixed interest rate, but used savings that could be withdrawn at any time for the loan, and interest rates went up because of the Fed's actions to slow the growth of the money supply, then banks could find themselves in the position of having to pay a higher interest rate than they were receiving from their outstanding loans. This would then produce a negative spread and the bank would lose money on those loans. We don't want banks to lose money because when a bank loses money we all have to come up with the difference and make them whole again. That is what we just went through.
So, banks need to make a positive spread, after their expenses, to stay in business. But, over the years commercial banks discovered that they could have more predictable earnings if they developed FEE business. What is FEE business? You know charging the customer a fee every time they did a transaction. Fee business became the way for banks to make money if they were not too good at reading the future movements of interest rates, the economy or the Fed's actions.
The situation today is that banks can borrow from 0 to .25% at the Fed window, and while interest rates now are very low, bankers are not very good at figuring out which way interest rates are going. Figuring that they can not go below zero, banks are thinking that at some time in the near future, the Fed is going to raise interest rates. There is a whole thing about matching assets with liabilities, called risk management, but you have to think to do that, and even though all these smarty pants have MBAs from top business schools, no one wants to stick their neck out.
So, we have the present situation where commercial banks do not want to loan money even to creditworthy customers. What can the Obama administration do about this? Not much is my answer, except to jaw bone with the big banks, which probably will do nothing. Remember, the banks have FEE business now and they do not have to loan money to make a profit.
Under another style of government, and I am not suggesting that this is the only way to get banks loaning money, a few bankers are taken out and put against a brick wall and a drama takes place and then every banker gets the idea and starts lending money again. The Obama administration and the Federal Reserve Bank's Chairman, Ben Bernanke, can only do so much to encourage banks to loan money. After saving their collective asses, we now have to be at their mercy to lend.