Low Margins and High Profits: An Economic Conundrum

Bankers are living in an economy they have never seen before. The U.S. government used fiscal deficits (lower taxes, higher expenditures) to help the recovery after the dot-com collapse resulting in a recession. The Federal Reserve Bank dropped interest rates to the lowest level in years (1%) and kept them low for a longer period then in the past.

The result of the Federal Reserve policies was a successful economic recovery after a short and shallow recession. The banking system remained strong and profitable during the slowdown. For once, the fiscal and monetary policy had been set early on and thus was well prepared to meet oncoming economic problems. (In the past, due to the government’s delay in addressing these needs, changes in fiscal and monetary policy often took effect after the recession.)

Now the economy is recovering, but it is happening in a whole new way. Even Alan Greenspan is puzzled by what the economy is doing. Usually a recovery is accompanied by rising long-term interest rates and the threat of rising inflation. Many bankers and hedge fund managers had bet this would happen in the current recovery, but as we all know, the economy hasn’t behaved as most expected (including me). In the words of the Fed, “Inflation is well contained,” and the reaction of the market shows 10-year government bonds paying an interest rate that is around 4% lower than a year ago.

The Fed has raised short-term interest ratesu00e2u20ac”the usual prescription for an economic recoveryu00e2u20ac”but the usual concurrent rise in longer interest rates hasn’t taken place. The yield curve is flat and getting flatter as the Fed continues to raise short-term rates. When asked why long-term rates were not behaving as they have in the past, Chairman Greenspan labeled it a “conundrum.”

This, then, should be a difficult environment for financial institutions that earn their income largely on spread. Yet 94% of banks are profitable and first quarter 2005 earnings were at a record level of over $34 billion.

As might be expected with the flat yield curve, interest margins dropped to a 15-year low. But, bankers made up for the loss of margin by the following:

• improving efficiency ratiou00e2u20ac”64% at small banks and 55% at large banks
• improving asset qualityu00e2u20ac”the recovery has helped borrowers meet their obligations
• improving revenuesu00e2u20ac”providing mortgages to the booming housing markets (which have been largely caused by the long-term interest rates).

This result is really a tribute to how far bank boards and senior executives have come in their ability to manage their operations in difficult times.

But can the banks continue to show record profits under current conditions? Probably not! In the long run, they can do only so much by cutting costs.

Higher volume is the only long-term prescription for profit growth. But, higher profits, in the longer term, depend on higher interest rates. This, in turn, probably means a slowing or the end of the record home mortgage origination business.

The period ahead will be difficult for bankers, but they can manage if changes in economic environment (interest rates) occur slowly. If there were to be rapid changes, things will get more difficult. As always, being an economic conservative (don’t bet much on what interest rates will do) seems like the best way to go in uncharted waters.