Declining Bank Margins Are Bad News

 | Mar 24, 2013 | 11:00 AM EDT  | Comments
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Bank lending in the U.S. has been steadily declining since the financial crisis of 2008, even as the Federal Reserve has been implementing monetary policies that are intended to encourage banks to make loans. 

The banks receiving the monetary stimulus have been using it for purposes other than lending, principally in the acquisition of liquid exchange-traded securities, and this has allowed banks' total earnings to increase along with their stock prices over the past four years.

This is not something that can continue indefinitely, though. The U.S. financial system and economy are predicated on debt-driven growth. In order for the economy to expand, banks must make loans. Unless banks start making new loans, the economy cannot expand, and the value of the securities they are holding will be at risk.

The two most important points to be aware of and to monitor with respect to this are the value of loans being created by banks and the net interest margin on them.

Every quarter, banks are required to report the status of these issues to their regulators in what are called "call reports." In the last three years, the total value of loans held by banks in the U.S. has increased by only 2.6%, an anemic average annual growth rate of 0.8%, from about $7.5 trillion in the first quarter of 2010 to $7.7 trillion by the end of 2012.

Although there are many reasons for the reluctance to lend and the preference for purchasing securities, one of the driving factors is the steady decline in net interest margins.

Net interest margin is measured as total interest income minus total interest expense, and it's expressed as a percentage of earning assets. It's the gross profit margin available in making loans and investing in other interest earning investments. It does not include capital gains, trading gains, service fees or other non-interest income.

In the past three years, banks' net interest margin has decreased steadily, from 4.3% in the first quarter of 2010 to 3.17% at the end of 2012.

What is most disturbing about this is that it has happened even though the Fed has doubled the size of its balance sheet over this period of time through the implementation of three rounds of quantitative easing that were designed to increase bank margins, promote the profitably of lending and therefore encourage both borrowing and lending activity.

Lower margins have also helped to cause quarterly interest income to decline from about $138 billion at the beginning of 2010 to $120 billion by the end of 2012, even though earning assets increased by about $1 trillion over the same period.

What appears to be happening is that as the yield difference between long-term and short-term rates shrinks, the profitability in making loans decreases and is causing lenders' aversion to lending to increase at a faster rate than borrowers' demands for loans is increasing.

Bankers, however, are claiming that the issue is not that they don't want to lend but that they can't find qualified borrowers and that they must therefore put reserves to work elsewhere rather than lending.

Regardless of whether the decline in bank lending is because lenders don't want to lend or borrowers don't want to borrow, bank lending is decreasing, and the Fed has been unable to reverse it so far. 

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