What your college econ class might have missed.
What role are banks to play in society? The way they are restoring balance sheets raises the question.
The banks are baaack. JP Morgan, Goldman Sachs and Citi all reported very profitable quarters last week. Most of the discussion on their performance has rested on the outsize profits from their trading desks. But there is another source of profits that is not merely incidental to the bottom line. Citi and many other banks now operate a relatively riskless operation-borrowing from the Fed and savers at sharply lower interest rates but lending out to the government, consumers and corporations at rates that have not fallen in tandem.
The standard econ 101 reason for lowering interest rates is to maintain aggregate demand by allowing real sector borrowers access to cheaper funds. In theory, as the Fed funds rate falls, banks can borrow at lower rates and pass on lower lending rates to the economy. In a competitive environment, when banks are healthy the spread should be low. In an uncompetitive industry, on the other hand, banks will keep some of the spread to repair their damaged balance sheets.
And this is certainly part of the story. Minimally, banks can run a relatively riskless operation by borrowing Fed funds in large volumes at 0.5% and buying treasuries at 3%.
But a lower borrowing rate for banks has another real cost. By making it easier for banks to borrow, they are less dependent on private short-term savers and can offer a lower rate to them. This is especially deadly for savers who need to keep their assets in liquid form-retirees, small firms with small surpluses in the money market, etc. Such individuals and firms are structurally trapped in the financial system. Banks' likely loss of customers from reducing short-term interest rates are negligible, since people with short-term assets such as MMFs and short term CDs are unlikely to shift to long-term assets because they need liquidity. The increased difference between the rate at which banks lend and the rate at which they borrow constitutes a gift to the banks from savers and borrowers. How much of a gift? Let's run with Citi's 10q from this quarter (page 33):
Note that since the last quarter, they've ramped up short-term borrowings by 40% on their liabilities side from $131 to $180 billion, or a difference of $51 billion. They are paying less interest on this than before-a difference of 28 basis points (0.9-0.62) on average. Now, look at their investments. Citi ramped up consumer loans by $95 billion (from $442 to $538 billion). The interest rate on consumer loans has, rather than coming down, actually increased by 160 basis points, from 8.13% to 9.73%. Now, this might be because of increased perceived risk, though this view would be hard to defend in a period of relative macroeconomic improvement, and probably instead reflects credit card expansion. The spread for this quarter from this channel is therefore1.6-(-0.28)= 1.88%. If I took in $51 billion of relatively captive funds, and earned a spread of 1.88%, I get approximately $960 million over a year, or nearly $250 million a quarter.
The example I use is (deliberately) the extreme case, and there have been assets on which Citi earned lower rates this quarter (notably on corporate loans). But note that in general, borrowing costs for Citi have gone down 15 basis points from 1.75% to 1.6%, but lending rates have gone up by 55 basis points. This brings us back to policy. Lowering Fed funds rate, if it does not also lower lending rates, represents a subsidy to banks and a neutering of the impact on effective demand.
We can even make a very rough estimate of the value of this subsidy over the last year for the overall banking system. First, take the total stock of savings and small time deposits, overnight repos at commercial banks, and non-institutional money market accounts in the US, or in other words M2-M1. This works out to approximately $6.8 trillion on average over the period. Take the difference in the rate of interest on a one year CD at the beginning of 2008 (3.9%) and now (0.7%) as a rough proxy for the lowered short term borrowing rate for banks in short term markets (3.9%-0.7%=3.2%). By contrast, the rate of interest charged by commercial banks for car loans, personal loans and credit cards has hardly changed between early 2008 and February 2010, and has fallen in the first two cases by only about 0.5%. Even if we are generous and double that figure, and say that lending rates on average fell by 1%, this means a gift of (3.2%-1%)*6.8 trillion, or about $150 billion, from savers to banks. This should rightly be considered a backdoor bailout, but not one that is directly accounted for in some high-profile discussions of it.
Note here that I am not suggesting that the Fed should not have cut rates. But there is often little traction in traditional monetary policy during a crisis, and it is entirely predictable that privately owned banks will seek to repair their balance sheets in whatever way they can, even if this means neutering monetary policy and undermining the progress of the real economy. That they are doing so by squeezing their clients is another bitter fact about the current financial world and just one more in a litany of horrors. And policy-wise, this is yet another unheeded argument for fiscal policy and prompt corrective action on banks.
Roosevelt Institute Fellow Arjun Jayadev is an assistant professor of economics at the University of Massachusetts, Boston, and a visiting research fellow at the Columbia University Committee on Global Thought.
