US small and medium-sized banks hit by interest rates

According to an analysis by Reuters, small and medium-sized banks in the US have started to take on risk as the squeeze in net interest margins is beginning to hurt profitability. The goal is to boost returns despite the low-interest rate environment by increasing risk and/or leverage. The analysis is confirmation that the Federal Reserve’s accommodative monetary policy is causing investors to reach for yield, underlining the concerns raised recently by Fed Governor Jeremy Stein. 

Reuters says that the firms most impacted by lower rates are smaller and regional banks. This dovetails with what I wrote in a post to subscribers in October that, “[t]his is a continuation of yesterday’s post on the outlook in the banking sector. Two years ago, I said that net interest margins at banks would get crushed by the Fed’s keeping interest rates low because it would cause the yield curve to flatten and diminish net interest margins. This has turned out to be true, particularly at regional banks that are more pure play banking franchises without significant investment banking or securities businesses.

Credit Suisse sees no upside in regional bank stocks as a result. Barron’s recently wrote that the intermediate EPS outlook at regional banks was negative not just on net interest margins but also on loan growth. Moreover, the regional bank stocks are trading as a sector at a relatively high forward 2014 P/E of 10.2 times earnings despite the fact that they have poor organic growth prospects due to the slowing in loan growth and the decline in net interest margins.”

The implication here is that large, so-called too big to fail firms can seize an advantage because of this, especially given their low funding costs, lowered by the implicit state guarantee due to their size. And indeed bank analysts like Meredith Whitney have expressed optimism about the prospects of large banks like Bank of America.

One strategy the smaller firms have employed is extending duration. That is they have begun buying assets with longer maturities. In Austrian Economics circles, this is considered a reliable outcome of artificially low interest rates because Austrians believe investors begin to favour investments in more “roundabout” methods of production when rates are low. The upshot then is that private portfolio preferences then shift to projects or assets that have payoffs further into the distance, re-allocating investment capital accordingly. When banks extend duration because of low rates, this is what happens.

Another inference from the Reuters analysis is that the squeeze in net interest margins on smaller and regional banks is causing them to move out of traditional lending activities and into riskier investment and trading activities in order to boost returns. Reuters writes:

“Running a bond shop is not my favorite way to deploy assets,” Commerce Bancshares Inc Chief Financial Officer Charles Kim said.

Since 2008, the Kansas City, Missouri-based bank’s investment portfolio has surged by $5.9 billion, or 156 percent, to more than $9 billion, and the bank has been buying longer-dated bonds. Investment securities account for 44 percent of the bank’s $22.2 billion in assets, compared with 22 percent in 2008.

“It is big. There is no denying that,” Kim told analysts and investors last month during a banking conference in Boston.

That growth is greater than average, but overall many regional banks are moving in the same direction. Securities books for these banks grew 20 percent from 2010 to 2012, outpacing overall asset growth of 16 percent, according to a Reuters analysis of 80 mid-size regional banks, with assets between $5 billion and $40 billion.

With so many investors pouring money into bonds of all stripes, banks are not earning the returns on longer-dated securities that they would hope for even in the near term.

This should make sense because the FDIC has reported that almost all of the increase in earnings from the record $141.3 billion in accounting gains at banks came from increased non-interest income and lower loan loss provisions, not from making more money on loans.

I continue to believe this is a destructive path. Bernanke and Yellen have both shown they are aware of the risks, but believe they have no other choice if they are to fulfill their dual mandate. My view: Easy money is not going to do for the US economy what people want it to do. The reckoning will come when the economy turns down and the misallocation of resources is made plain. Until then: caveat emptor

Source: Reuters

Also see: Defying Gravity: Miami Condos Soar Again

Update 1535 EDT: The Fed has issued another interest rate statement today. Bernanke has also spoke. And the Fed is now saying that it expects unemployment of 6.7% to 7.0% in 2014. The Fed has also previously said that it will not raise rates until the unemployment level is 6.5%. This is a huge green light for leveraged speculation using Treasuries as a funding vehicle and it also means that the problems that small and mid-sized banks are having with lower net interest margins will continue. These banks will be forced to reach for yield.

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