Fed’s ZIRP policy and Banks’ Net Interest Margins

Why is it that banks want Fed to increase rates? Some say, that higher rates will lead to higher net interest margin for the banks.

But Noah Smith says there is hardly any linkage between the two.

First of all, if we simply look at the history of interest rates and net interest margins, we don’t see much of a relationship at all:

FFR and nim

The fed funds rate has been falling since the early 1980s, but until the mid-1990s, net interest margins actually rose. After 1994, net interest began a steady but very slow decline that continues to this day. During this whole time, the fed funds rate has gyrated dramatically, but net interest has barely budged in response to those swings. A careful time-series analysis might be able to tease out some sort of a relationship there, but I don’t see it. 

Then there’s the lack of a good theory for why lower interest rates should compress banks’ margins. Changes in the fed funds rate should affect both long-term and short-term rates equally. If the Fed tightens, depositors will demand higher deposit rates from banks, and banks will demand higher interest from borrowers. After an initial period of adjustment (to allow for existing loans to roll over), the effect of rate changes on spreads shouldn’t be substantial. 

Now, as Krugman points out, deposit rates — like the federal funds rate — are stuck at zero. If deposit rates stay at zero while the returns on bank loans fall, that does indeed compress banks’ margins. But it’s very hard to see how Fed tightening would help that situation at all. As David Henry of Reuters points out, that would just increase banks’ costs in the short run. On top of that, if rate hikes slow economic growth — as they did in the early 1980s — that will hurt banks’ profits even more. 

If banks really do think that Fed tightening would boost their bottom lines, history is not on their side. When Japan temporarily ended its own ZIRP in 2006, the result was simply higher costs for banks, with no corresponding rise in profits. 

So if we want to find the reason that Wall Street wants higher interest rates, we should probably look elsewhere. Here’s a thought: perhaps high rates make it easier to charge bigger percentage fees at every stage of the investment process. But that’s a topic for another column.

The bigger question is if central bank policies are not leading to any meaningful real economy outcomes or financial economy outcomes, why have it at all?

Comparison to Japan may not be a good one that too just one episode. Japanese banking system is very different from that of US. But then there are not many other examples as well..

 

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