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Here’s the 'snoozing' giant that could crush bank stocks

  • Banks are paying depositors historically low interest rates, even as the Fed is pushing rates higher.
  • The average household doesn't have the power to force banks to up the ante.
  • Corporate treasurers however, could awaken from their "somnolent state" and demand a better deal, which will hurt bank stocks.
A replica of the famous Godzilla in Tokyo.
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A replica of the famous Godzilla in Tokyo.

The banking industry is not paying depositors and fund providers reasonable rates for their money, according to data from the Federal Deposit Insurance Corporation (FDIC) which insures those deposits. Households and corporate treasurers seem to be oblivious to the fact that interest rates are rising. Consequently, banks are able to pay historically low rates for money and no one who provides the banks with funds seems to care.

One might argue that households lack the power to demand more for their deposits and this may be true. Corporate treasurers, on the other hand, do have some power over what they demand for their funds. The numbers show they are either "snoozing" or they are just not doing their jobs.

History shows, this cannot last.

The Numbers Swing

The numbers are relatively compelling. In the twenty years from 1987 to 2007, the effective Federal Funds rate fluctuated wildly. At one point, the quarterly average was 9.85 percent and toward the end of the period it was 0.98 percent. Through the period it averaged 4.88 percent. Similarly, banks' payment for money fluctuated significantly from 7.92 percent to 1.79 percent. During the period, bank funding costs averaged 4.18 percent. Basically, on average, the Federal Funds rate, through this 20 year period, was about 17 percent higher than the rate banks paid for money.

This changed dramatically following the financial crisis. The Federal Reserve began to subsidize that Federal Funds rate so it averaged 0.79 percent from 2007 to the first quarter of 2017. Banks were facing different pressures. Their financial credibility was being questioned by the markets so they were only able to cut their average cost of funds to 1.07 percent in the same period (numbers are not available for the second quarter of 2017). Now, the banks were paying more for money, 35 percent more, than the Federal Funds rate.

Banks Profit at Corporate Treasurer's Expense

This was a good deal for corporate treasurers, especially for companies like Apple with billions in cash on hand. It was a good deal until the Federal Reserve began to increase interest rates in December 2015 and the banks did not. Moreover, the Fed continued to keep raising rates through 2016 and into 2017 while the banks held the line. They refused to pay up for funds. One reason was the money flowing out of Institutional Money Market Mutual Funds, due to a change in regulations, may have flowed into banks.

At the present time, the effective Federal Funds rate is 1.16 percent and I estimate banks are still only paying 0.45 percent, on average, for money. The banking industry is only paying a little more than one third the Federal Funds rate, overall, for new money. It is paying about one tenth of the Federal Funds rate for deposits.

The biggest banks are paying depositors an estimated 0.11 percent to 0.13 percent for new deposits and turning around and lending this money out at 1.16 percent in the Federal Funds and Overnight markets. This is a very good deal for banks but maybe not such a great deal for corporate treasurers and households.

History Says "No Way"

The history of rates is relatively clear. The Federal Reserve leads the rate markets up or down. Banks follow. If this pattern holds true, banks are going to start paying a great deal more for money. This will lower their profit margins and reduce their potential earnings growth rates.

Do bank executives see this as a real possibility? Bank of America is a clear example that they do. For years that bank would publish "bubble" charts showing how much money it would make if interest rates were to rise by 1 percent. In its second quarter conference call, bank management stated that it would no longer make these projections. One reason is that the bank's profit margin, its net interest margin, actually fell in the quarter despite the multiple rate increases put in place by the Fed.

It is now a real possibility that corporate Boards of Directors are likely to waken corporate treasurers from their somnolent state and demand higher returns on their deposits. If this happens, as expected, banks will not benefit from rising interest rates contrary to investor expectations.

From March 1, 2017 to the present, the KBW Bank Index has declined by 2.8 percent while the S&P 500 is up by 3.0 percent. The interest rate dilemma is one reason. Until it is resolved bank stocks are likely to continue to underperform, particularly those in the regional grouping.

Commentary by Richard X. Bove, an equity research analyst at Rafferty Capital Markets and the author of "Guardians of Prosperity: Why America Needs Big Banks" (2013).

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