THE BLOG

Low Interest Rates are Bonanza to the Banks

Mar 18, 2010 | Updated May 25, 2011

Banks have been frustrating the administration's efforts of economic revival by being reluctant to lend, and the president has been complaining about it.

But that is to be expected. Banks are behaving rationally in response to the environment created by the Treasury and the Federal Reserve, i.e. interest rates at effectively zero. They are simply engaged in yield curve arbitrage.

Zero interest rates mean that banks can borrow short-term and use the money to buy risk-free 10-year Treasury bonds that yield 3.5%. That trade is very profitable and makes sense for the banks.

Banks are in the business of lending and do not need encouragement to sell their product, any more than a grocery store needs incentive to sell milk or bread. However, why would anyone take unnecessary risk when the spread is so easy, and so obvious? Traditional lending is hard work, and a risky endeavor to boot.

In addition, with yields on investment grade debt higher than the economy's growth rate, it is not financially viable to lend. The cost of new debt is higher than what most businesses can earn. That is why businesses are delevering and banks are loath to lend.

Banks were already earning oligopolistic profits on mortgage spreads. And they already had the PPIP initiative, which is essentially a leveraged transaction aimed at transferring the bank's worst assets to greater fools (in this case an unsuspecting public), saving them from their own toxic assets. Low interest rates are just another boost to their business, at a time when they need a boost, having gone to the brink of implosion last year.

So the policy of the Federal Reserve Bank is creating massive profits for banks. That may be the constituency the Obama administration wants to serve at the moment, despite its vocal admonitions to the contrary. But it will not help consumers and small businesses, who depend on banks for credit.

And without small businesses, economic growth and job growth will not return.

Alan Schram is the Managing Partner of Wellcap Partners, a Los Angeles based investment firm. Email at aschram@wellcappartners.com.