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The Federal Reserve Works for Bankers

It has now been two decades, nearly to the day, since the Head of Capital Markets at a ‘super-regional’ bank explained to me that traditional banking was a dinosaur because it was dependent on the level of interest rates for profitability. More precisely, it was dependent on the ‘slope’ of the yield curve, the difference between long term and short term interest rates. When banks can pay 1% for reserves and make loans at 8% they are wildly profitable. But when the situation reverses, when short term interest rates rise above longer term interest rates, bank profits tend to fall. With the experiences of the late 1970s – early 1980s and 1994 when the Federal Reserve raised short term interest rates then fresh, the traditional banking model was declared dead in favor of Wall Street style investment banking.


Graph (1) above: When interest rates fall bank profits tend to rise and vice versa. The long decline in interest rates beginning around 1982 has been a bonanza for banks, the larger of which shifted from lending to financial speculation, the ‘Wall Street’ model. Seen here are the long-term trends in interest rates and bank profits. As interest rates have fallen bank profits have risen. While the Federal Reserve typically only controls the Federal Funds rate, the overnight price of bank reserves, the BAA yield generally tracks the Federal Funds rate and adds a ‘risk premium’ for default risk. It is inversely related to corporate bond prices— when interest rates fall corporate bond prices (and the value of fixed-rate bank loans) rise.

A version of the old banking model was recently raised from the dead to argue that ‘net interest margin,’ the slope of the yield curve as it relates to the prices of bank reserves and loans, is the major source of bank profitability. In this theory, bankers want higher interest rates because??? The sophisticated version of the argument attempts to address net interest rate exposure— the effect of interest rate changes on bank asset values and cash-flows (net interest margin) after bank ‘hedges,’ or offsetting exposures, are taken into account. The less interesting version argues that higher Federal Funds rates boost net interest margin by (?) flattening the yield curve? Bankers then obviously want higher interest rates to??? (Net interest margin is a function of the slope of the yield curve, not the level of short-term interest rates).

The big picture here is that coming out of the 1970s a combination of political and economic factors joined to create the current epoch of finance capitalism that is still unfolding. Economists can argue theory all that they care to, but bank (Wall Street) profits increased exponentially as the thirty-year trend lower in interest rates played out. My critique is that this combination of politics and economics, particularly the ever-lower cost of credit— interest rates, has instantiated finance ever-deeper into ‘the economy’ and that it has created the circumstance where any sustained rise in interest rates will cause the system of inter-related bank exposures to unravel. Experience from overseas has seen central banks quickly retreat from every attempt to raise interest rates in recent years.

There are a large number of ways of organizing and presenting this data. If financial profits were scaled to enterprise values or economic growth they would appear less robust. But in a basic way, that is my point. Interest rates are an essential part of an integrated economic process that has created the world which we now share. The entire public sphere is in the process of being financialized through the integration of privatization and the ever deeper instantiation of finance. Economists can build models that are premised on impermeability, on the limited impact of the way we live on the way we live. But taking a step back, finance has grown as a share of ‘the economy’ as interest rates have fallen. The desirability of this is a topic for social push and pull. But arguing its fact seems less than either interesting or constructive.