How the Fed Has Stuck it to Smaller Banks

Earlier this week, Ben Bernanke announced that the Federal Reserve is going to engage in another round of quantitative easing. This time, the Fed will pump $600 billion into the economy in an effort to stimulate growth. We have already seen some quantitative easing (a tactic that gets its name from the fact that it works by adding a large quantity of money to the system) since the financial crisis, and we continue to see a Fed Funds rate that is practically 0% (officially, it’s between 0% and 0.25%).

These actions, though, are more than just a way to stimulate the economy; they could also end up creating a losing situation for some of the smaller banks in the U.S. The health of many banks is not all that terrible right now, but it doesn’t mean that some of them aren’t getting the shaft in some way. Indeed, while the Fed has been busy trying to save the banks that are “too big to fail,” some of the policies enacted could actually be forcing a change in some of the ways that smaller banks do business – and not necessarily for the better.

Ira Artman wrote an interesting article on Seeking Alpha in December of 2008 about the issues that could arise for small banks as a result of some of the Fed’s actions. “How the Fed’s Rate Cut Could Hurt America’s Small Banks” remains applicable today as low rates persist.

Artman points out that the policies pursued by the Federal Reserve encourage almost the opposite business practices that have helped small community banks thrive in recent years. He points out that, for the most part, the largest banks in the nation, with their exposure to riskier loans, were in bigger danger of collapsing than the small banks, with their focus on customer relationships and reluctance to securitize mortgages and sell them off. However, Fed policy since the financial crisis has created a situation in which small banks need to securitize loans so that they can turn profits. Here is what Artman points out about the possible results of the process:

As the smaller banks sell off assets that no longer make sense on their balance sheets, they will be turning them over to the large bank aggregators. This is because the largest banks, unlike the smallest, have used their size and clout to achieve or negotiate rock-bottom securitization and servicing costs. Smaller banks will not be able to duplicate these terms. As this process continues, the larger banks will earn – good, bad, or indifferent – a larger portion of the revenue stream than they had previously received, and which had enriched the smaller banks.

Part of the quantitative easing plan from the Fed is to buy short-term Treasuries. This move is designed to raise prices on long-term bonds, which pushes down yields (since prices on bonds move inversely to yields). As long-term bond yields drop, mortgage rates and rates on other loans with longer terms are expected to drop as well. The Fed hopes this will spur borrowing by consumers who want to take advantage of low interest rates. Increasing the money supply can also have the effect of forcing banks to lend – even if it isn’t in their best interest. With quantitative easing forcing Treasury yields lower, it makes it difficult for banks to avoid loaning out money.

Mark Sunshine, author of the Sunshine Report, explains why banks need to loan out money. He points out that, even if banks were to pay depositors a rate of 0%, there would still be costs associated with holding the money. So, without different low-risk investments to make up for these costs, small banks have to lend. Banks that want to build their cash reserves and reduce their balance sheet risk use investments that are considered “as good as cash” to help them offset the costs of paying depositors a yield without lending as much. Sunshine says, in “How the Fed is Making Banks Lend”, that Fed moves since the financial crisis are reducing options for many banks:

The types of investments that the Fed is initially targeting to drive down yields include Treasury securities, Federal Funds, Agency bonds and Agency and government guaranteed mortgage backed securities. These investments have historically been considered low to no risk investments that are as good as cash. One by one, the Federal Reserve is going to take away the hiding places that banks have used to avoid lending.

It has been two years since Sunshine wrote those words, but the situation hasn’t changed all that much. The economy is still in a funk, and the Fed is still trying to get things going with the help of continually low interest rates and quantitative easing.

Because the strategy is meant to continue the cycle of debt-fueled consumer spending that led to past economic booms, the focus is on getting banks to lend to borrowers. Even if those borrowers are somewhat risky. However, this focus, and the quantitative easing that is meant to encourage banks to lend using the increased money supply, might only service to help matters in the short term. This is because such a policy does not represent true investment; it leads to speculation about asset prices and possible inflation.

And, for the long term, we could find that permanent zero interest rates and quantitative easing only make things worse for the banks. Edward Harrison writes, in “How Quantitative Easing and Permanent Zero are Toxic to Bank Net Margins”, that banks could see bigger losses down the road, especially if current efforts fail to kickstart the economy:

What’s more is that PZ [Permanent Zero] will be a big problem in a Shiller double dip scenario because banks will be set up for huge loan losses despite recent under-provisioning. Meanwhile they will have no way to make it back on net interest as long rates come down in a recession while short rates remain at zero percent, killing net interest margins.

So, even though the Fed is trying to stimulate the economy, some banks may end up being sacrificed, in some ways, to what is seen as the greater good. And, of course, as long as these policies remain in place, savers are likely to continue getting the shaft as borrowing by consumers is encouraged as a way to save the economy.