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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.

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  |     |   Comment #1
I'm still puzzled as to why Congress would allow banks to become "too big to fail". It sounds like another way of saying this folks have a monopoly going on, but we're just not going to acknowledge that.
  |     |   Comment #3
#1   as to why Congress continues to allow banks to become to big to fail, just look at who is contributing to their campaign funds. They are not going to completely chop off the hand that feeds them.  That is just political reality.
  |     |   Comment #2
Great article, really addresses the issue.  Thanks for prviding it to the readers. Absolutely great.
  |     |   Comment #4
they are too big to fail because the government is a revolving door for the big banks.  Obama's economic team is all Wall Street connected as was Bush's economic team before them.  As they point out in the critically acclaimed new documentary "Inside Job"  "It's a Wall Street government"
  |     |   Comment #5
Poor article based many misunderstandings and false assumptions, jumping to erroneous conclusions. 
  |     |   Comment #9
Anonymous - #5 and 7, it never ceases to amaze me how folks like you pan articles that are full of careful analysis, facts, logic, reason and common sense, claiming that they are "alarmist garbage" for example, while, at the same time, not offering any facts, logical analysis, or reason to back up your claims. 

In psychology, it is called being in "denial" and occurs when you encounter opinions that people would realize are true, except for the fact that accepting that truth conflicts with some personal matter they are involved in, or, in the case of investing, with some financial position they've taken.  It is a VERY dangerous state of being.

Investors are often afflicted with this malady.  It is what causes otherwise rational people to ride a stock or bond all the way down to the bottom.  It prevents people from taking correct action to protect themselves.  Right now, for example, just about the worst investment, thanks to the manipulations of the Federal Reserve, are CDs and bonds.  They are denominated in a currency that is will lose about 3/4 to 5/6ths of its value in 3-5 years.  Over the last 95 years, the dollar has lost 99% of its buying power (mostly since 1971 when the tie to gold was fully broken), as measured against gold. 

Amazingly, folks still willingly lock their money in long term CDs, even now, when the pending demise of the dollar is obvious.  This is because they cannot accept the fact that the middle class is about to have most of its savings wiped out, as a result of dollar debasement.
  |     |   Comment #10
Looks like someone is sensoring the comments!
  |     |   Comment #11
If you can't stand the heat, get out the kitchen, Miranda.  You won't silence your critics by deleting their posts.
  |     |   Comment #12
Ken, stop deliting the post that are critical of or not on the same wave lenght with your opinions.

You can learn more from a negative comment than a praise to your ego.
  |     |   Comment #13
Um, #11 (and anyone else), I'm not in charge of deleting comments. I don't even post, since I don't have access to the platform, a decision I would think that you would applaud. Ken posts my stuff, after I send it to him and he reads through it. I assume that he is also in charge of deleting comments. I don't censor anything. I know I have plenty of critics, since I am not perfect as so many of these anonymous commentors seem to be. But, hey, I try.

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