Interest Rates and Bank Spreads

So the Fed decided not to raise rates this weeks. And as you’ve probably seen, this provoked an angry response from representatives of financial institutions. The owners and managers of money have been demanding higher interest rates for years now, and were clearly hoping that this week they’d finally start getting them.

As Paul Krugman points out, it’s not immediately obvious why money-owners are so hostile to low rates:

I’ve tried to understand demands that rates go up despite the absence of inflation pressure in terms of broad class interests. And the trouble is that it’s not at all clear where these interests lie. The wealthy get a lot of interest income, which means that they are hurt by low rates; but they also own a lot of assets, whose prices go up when monetary policy is easy. You can try to figure out the net effect, but what matters for the politics is perception, and that’s surely murky.

But, he has a theory:

What we should be doing …  is focusing not on broad classes but on very specific business interests. … Commercial bankers really dislike a very low interest rate environment, because it’s hard for them to make profits: there’s a lower bound on the interest rates they can offer, and if lending rates are low that compresses their spread. So bankers keep demanding higher rates, and inventing stories about why that would make sense despite low inflation.

I certainly agree with Krugman that in thinking about the politics of monetary policy, we should pay attention to the narrow sectoral interests of the banks as well as the broader interests of the owning class. But I’m not sure this particular story makes sense. What he’s suggesting is that the interest rate on bank lending is more strongly affected by monetary policy than is the interest rate on bank liabilities, so that bank spreads are systematically wider at high rates than at low ones.

This story might have made sense in the 1950s and 1960s, when bank liabilities consisted mostly of transactions deposits that paid no interest. But today, non-interest bearing deposits compose less than a quarter of commercial bank liabilities. Meanwhile, bank liabilities are much shorter-term than their assets (that’s sort of what it means to be a bank) so the interest rates on their remaining liabilities tend to move more closely with the policy rate than the interest rates on their assets. So it’s not at all obvious that bank spreads should be narrower when rates are low; if anything, we might expect them to be wider.

Luckily, this is a question we can address with data. Historically, have higher interest rates been associated with a wider spread for commercial banks, or a narrower one? Or have interest rate changes left bank spreads unchanged? To answer this, I looked at total interest income and total interest payments for commercial banks, both normalized by total assets. These are reported in a convenient form, along with lots of other data on commercial banks, in the FDIC’s Historical Statistics on Banking.

The first figure here shows annual interest payments and interest costs for commercial banks on the vertical axis, and the Federal funds rate on the horizontal axis. It’s annual data, 1955 through 2014. The gap between the blue and red points is a measure of the profitability of bank loans that year. [1] The blue and red lines are OLS regression lines.

Fig. 1: Commercial Bank Interest Paid and Received, as a Share of Assets, and the Federal Funds Rate

If Krugman’s theory were correct, the gap between the blue and red lines should be wider on the right, when interest rates are high, and narrower on the left, when they’re low. But in fact, the lines are almost exactly parallel. The gap between banks’ interest earnings and their funding costs is always close to 3 percent of assets, whether the overall level of rates is high or low. The theory that bank lending is systematically less profitable in a low-interest environment does not seem consistent with the historical evidence. So it’s not obvious why commercial banks should care about the overall level of interest rates one way or the other.

Here’s another way of looking at the same thing. Now we have interest received by commercial banks on the vertical axis, and interest paid on the horizontal axis. Again, both are scaled by total bank assets. To keep it legible, I’ve limited it to the years 1985-2014; anyway the earlier years are probably less relevant for today’s banking system. The diagonal line shows the average spread between the lending rate and the funding rate for this period. So points above the line are years when bank loans are unusually profitable, and points below are years when loans are less profitable than usual.

Fig 2: Commercial Bank Interest Paid and Received, as a Percent of Assets

Here again, we see that there is no systematic relationship between the level of interest rates and the profitability of bank loans. Over the whole range of interest rates, spreads are clustered close to the diagonal. What we do see, though, is that the recent period of low interest rates has seen a steady narrowing of bank spreads. Since 2010, the average interest rate received by commercial banks has fallen by one full percentage point, while their average funding cost has fallen by a bit under half a point.

On the face of it, this might seem to support Krugman’s theory. But I don’t think it’s actually telling us anything about the effects of low interest rates as such. Rather, it reflects the fact that bank borrowing is much shorter term than bank lending. So a sustained fall in interest rates will always first widen bank spreads, and then narrow them again as lending rates catch up with funding costs. And in fact, the recent decline in bank spreads has simply brought them back to where they were in 2007. (Or in 1967, for that matter.) No doubt there are still a few long-term loans from the high-rate period that have not been refinanced and are still sitting profitably on banks’ books; but after seven years of ZIRP there can’t be very many. There’s no reason to think that continued low rates will continue to narrow bank spreads, or that higher rates will improve them. On the contrary, an increase in rates would almost certainly reduce lending profits initially, since banks’ funding rates will rise more quickly than their lending rates.

Now, on both substantive and statistical grounds, we might prefer to look at changes rather than levels. So the next two figures are the same as the previous ones, but using the year over year change rather than absolute level of interest rates. In the first graph, years with the blue above the red are years of widening spreads, while red above blue indicates narrowing spreads. In the second graph, the diagonal line indicates an equal change in bank lending and funding rates; points above the line are years of widening spreads, and points below the line are years of narrowing spreads. Again, I’ve limited it to 1985-2014.

Fig. 3: Year over Year Change in Commercial Bank Interest Received and Paid, as a Share of Assets, and the Federal Funds Rates


Fig. 4: Year over Year Change in Commercial Bank Interest Received and Paid, as a Share of Assets


Both figures show that rising rates are associated with narrower commercial bank spreads — that is, less profitable loans, not more profitable. (Note the steeper slope of the red line than the blue one in Figure 3.) Again, this is not surprising — since banks borrow short and lend long, their average funding costs change more quickly than their average lending rates do. The most recent three tightening episodes were all associated with narrower spreads, not wider ones. Over 2004-2006, banks’ funding costs rose by 1.5 points while the average rate on their loans rose by only 1.3 points. In 1999-2000, funding costs rose by 0.55 points while loan rates rose by 0.45 points. And in 1994-1996, bank funding costs rose by 0.6 points while loan rates rose by 0.4 points. Conversely, during the period of falling rates in 2007-2008, bank funding costs fell by 1.7 points while average loan rates fell by only 1.4 points. Admittedly, these are all rather small changes — what is most striking about banking spreads is their stability.  But the important thing is that past tightening episodes have consistently reduced the lending profits of commercial banks. Not increased them.

Thinking about the political economy of support for higher rates, as Krugman is doing, is asking the right question. And the idea that the narrow interests of commercial banks could be important here, is reasonable on its face. But the idea that higher rates are associated with higher lending spreads, just doesn’t seem to be supported by the data. Unfortunately, I don’t have a simple alternative story. As the late Bob Fitch used to say, 90 percent of what happens in the world can be explained by vulgar Marxism. But banks’ support for hard money may fall in the other 10 percent.



UPDATE: For what it’s worth, here are the results of regressions of average interest received by commercial banks and of and their average funding costs, on the Federal Funds rate. Both interest flows are normalized by total assets.

Full Period (1955-2014) 1955-1984 1985-2014
Coefficient r2 Coefficient r2 Coefficient r2
Funding 0.51 0.77 0.56 0.85 0.61 0.92
(0.04) (0.04) (0.03)
Lending 0.54 0.69 0.61 0.85 0.67 0.89
(0.05) (0.05) (0.04)
Funding 0.30 0.67 0.22 0.60 0.42 0.86
(0.03) (0.03) (0.03)
Lending 0.30 0.67 0.25 0.63 0.39 0.79
(0.03) (0.04) (0.04)

Again, we don’t see any support for the hypothesis that spreads systematically rise with interest rates. Depending on the period and on whether you look at levels or changes, you can see a slightly stronger relationship of the Federal Funds rate with either bank lending rates of funding costs; but none of these differences would pass a standard significance test.

Two positive conclusions come out of this. First, all the coefficients are substantially, and significantly, below 1. In other words,  the policy rate is passed through far from completely to market rates, even in the interbank market, which should be most closely linked to it. Second, looking at the bottom half of the table, we see that changes in the policy rate have a stronger affect on both the funding and lending rates (at least over a horizon of a year) today than they did in the postwar decades. This is not surprising, given the facts that non-interest-bearing deposits provided most bnk funding in the earlier period, and that monetary policy then worked through more limits on the quantity of credit than interest rates per se. But it’s interesting to see it so clearly in the data.


UPDATE 2: Krugman seems to be doubling down on the bank spreads theory. I hope he looks a bit at the historical data before committing too hard to this story.


VERY LATE UPDATE: In the table above, the first set of rows is levels; the second is year-over-year changes.


[1] This measure is not quite the same as the spread — for that, we would want to divide bank interest costs by their liabilities, or their interest-bearing liabilities, rather than their assets. But this measure, rather than the spread in the strict sense, is what’s relevant for the question we’re interested in, the effect of rate changes on bank lending profits. Insofar as bank loans are funded with equity, lending will become more profitable as rates rise, even if the spread is unchanged. For this reason, I refer to banks average funding costs, rather than average borrowing costs.

24 thoughts on “Interest Rates and Bank Spreads”

  1. One area where Krugman’s thesis holds true (at least from my interaction with players in the space) is trying offer positive yielding, short duration products to bank customers (most common: money market accounts).

    Admittedly, money-market accounts aren’t yielding much above 0% these days, but from anecdotal conversations they’re actually costing the institutions offering them a fair bit… many are explicitly waiving their management fees to keep the yield positive.

    I’d expect the first move up in rates to be associated at least with a return to profitability on these funds. While I agree with your data on the macro front (and the intuition seems correct) there may be other micro-situations that act like this as well?

  2. Interest on reserves is on the order of $50 billion a year, compared with about $450 billion in total interest income for commercial banks. So not trivial, but small. Possibly could become important when/if rates do rise, since IOR will presumably rise faster than interest income from loans.

    1. This is a great post.

      On IOR, I think the issue there is how many bank reserves are forced on banks, since in that case there is no possibility of maturity transformation so reserves and corresponding liabilities are earning about the same thing (reserves on average should earn a bit more, but not all corresponding liabilities would be interest-free deposits). In other words, it would seem nearly impossible to earn the consistent spreads you show above on the IOR portion of the bank balance sheet. Otherwise, prior to IOR banks would have just loaded up on tbills–no reason to lend and take a risk if you can earn the desired spread by holding tbills only, and we know they didn’t do that.

      1. Thanks Scott!

        You’re right, to a first approximation, IOR is equal to the interest rate on bank liabilities, not bank assets. So there’s no spread there.

        This raises a questions I’ve been thinking about, which you might have some ideas on. First, is there any channel from the policy rate to market rates except via bank funding costs? It seems to me that the most straightforward answer is no — with the current policy instruments, the only way the Fed can move market rates is via bank funding costs. In which case it’s not even logically possible for low rates to compress spreads. But of course the real world may be more complicated.

  3. I have not looked at the data, but it matches what I would expect based on bank behaviour. Banks do not run duration mismatches, and they slap a spread on loans based on their cost of funds. Their margins should be stable across the cycle.

    They just like hard money for political reasons, which I believe Kalecki observed in the 1940s.

  4. There are a lot of good points being made, but instinctively – not a good idea I know – I have to got with Krugman.

    Zoom out and take the broadest possible view of the situation. The Fed is rationing credit. By hiking rates it is making credit more expensive. Bankers know this. They want to be able to charge more for their loans.

    Like I said I am not 100 percent sure on this. The actual data may point in another direction or *does.*

    But it seems to me that there are lot of complicating factors between here and there.

    How competitive are the banks’ loan markets?

    The short-term loans banks need to take may become more expensive, but say they survive the new tougher environment while a competitor goes out of business.

    They can charge more for their loans because the Fed has set a higher baseline.

    Is this notion of profitability the best measure?

    At low interest rates all of the banks have to compete in order to stay in business.

    At higher interest rates, the same thing, but maybe fewer banks survive even if the profitablity of banks overall remains the same.

    I’m repeating myself, but the ones left get to charge more even if profitability is the same.

    It’s like farmers watching the government set prices on their commodity. They’re making money on low or high prices but would rather see higher prices.

    Interest on excess reserves is like paying the farmers not to sell their crops.

  5. DeLong appears to disagree with Krumgan. A commenter there says something along the lines I was thinking. Not exactly but similiar:

    “I suspect it is simply that bankers borrow short and lend long so as a general rule, they would always prefer that the Fed’s interest rate be as high as possible without triggering defaults as it reduces the chance of a future rate increase, and increases the chance of a future rate cut. They are reluctant to lend long at current rates because they can only go up.”

  6. There are a lot of good points being made, but instinctively – not a good idea I know – I have to got with Krugman.

    To be honest, if it’s a question of me vs. Krugman, you’re always smarter to go with him unless I’m making a very strong case the other way. So I think you’re instincts are sound.

    That said, what I think you are missing in this case is that banks are users as well as providers of credit.

  7. I suspect part of the missing picture is that in the ZIRP/QE environment, the interbank market is basically non-functional.

    I suspect we have a long chain of influence. The interbankers are the guys who really care about interest rates. They influence bankers as a whole, who then express “rate rage” which the financial press treat very seriously.

    Part of the issue here is that most economic reporting is the stenography of Wall St analysts and bankers opinions.

  8. Pre-2008, deposits were a profitable standalone business. Now they aren’t. This is because deposit rates didn’t go negative; they went to zero. In effect, interest-bearing accounts have been silently converted into non-interest-bearing accounts to the benefit of customers.

    1. I don’t see it. How can reducing the policy rate reduce profits on taking deposits? Banks pay interest to depositors, not vice versa. And they don’t need deposits to acquire assets. So if deposit-taking is/was profitable, I would think it must be because of the associated fees.

      1. Because when banks get deposits of monetary base they use it to buy govt bonds to earn money but now with ZIRP/QE they can’t?

  9. I think there are many factors at play here and want to suggest one:

    Banks still do perform maturity transformation — MZM ranged between 50-100% of GDP, so that is a lot of cheap deposits for banks. When FedFunds are cut, the result is a spike in net interest margins. It takes a while before long term yields fall, but they keep falling if the short rate is not quickly increased.

    Therefore to get the highest net interest margins, you want rate cuts that are only temporary.

    I don’t think this shows up in measures of net interest *income* because the quantity borrowed is also sensitive to the rate.

    But banks, like everyone else, doesn’t have good information about price elasticity of demand. In which case you bias your distribution towards “no change”.

    Here they are like all businesses, which regularly over-estimate the gains in revenue as the result of a price increase, and regularly underestimate the gains in revenue as a the result of a price cut.

    Trying to tell a bank, yes your net interest margin is going to be higher but you will have fewer borrowers so your net interest income isn’t going to change (and may even decrease) is a tough sell. Just as advising a store to not raise their price or to cut their price is a tough sell.

    1. My prior was just what you say here — that rates on bank liabilities adjust faster than on bank assets, so over the short run, up to several years, a rate cut should be associated with wider spreads. I was quite surprised to find that over a one-year horizon, the correlations of both rates with the policy rate were almost exactly equal, and that there was no systematic relationship between spreads and the change in rates.

      You’re right of course that I am not strictly looking at rates here, since banks have both non-intrest bearing liabilities and non-interest-bearing assets (including their buildings and so on) so if balance sheets shrink when rates rise, as you suggest, that will dampen the apparent response of rates to policy changes. I suppose I could redo the estimates without those. But from the point of view of bank profitability the way I actually did it is more relevant, no?

      Therefore to get the highest net interest margins, you want rate cuts that are only temporary.

      Isn’t what you want continuously falling rates?

      Trying to tell a bank, yes your net interest margin is going to be higher but you will have fewer borrowers so your net interest income isn’t going to change (and may even decrease) is a tough sell.

      This makes sense. But the problem is, as far as I can tell their net margins AREN’T higher. And thinking more about it, it seems to me that the only way policy can move lending rates, is via funding costs. So I’m not sure it’s even logically possible for tighter policy (using current instruments) to widen spreads.

      Another hypothesis is that banks are just channeling the preferences of their clients/owners, wealthy households, who are net lenders.

      1. I guess we disagree here about the correlations. I don’t think the regressions you calculated are meaningful because this is a dynamic situation with a lot of noise. Let me try make a simple dynamic model:

        Depositor gets paid MZM Own Rate and the banks take that money and invest it in safe short term assets getting FedFunds. This yields a seignorage “revenue” that can be normalized as:

        SR = (MZM Own Rate – FF)*MZM/GDP

        In a perfect competition world, MZM Own Rate – FF would be a constant spread reflecting bank costs of providing the deposits.

        In a rational consumer world (with no switching costs) MZM/GDP would adjust so that even in the absence of competition, the seignorage revenue would be constant — households would hold fewer deposits if the return was too low to justify the liquidity services.

        In neither of the above models would SR move with fed funds.

        Yet that’s exactly what it does.

        So you can excuse the banks for thinking that if FedFunds goes up, so will their Seignorage Revenue.

        The real question is whether the increase in seignorage revenue is offset by a decline in borrowers so that total income remains fixed. But again, you can excuse the banks for believing that the offset wont be one for one.

        So it makes sense that banks believe that an increase in FedFunds will increase their profits. Obviously this doesn’t mean an excessive increase, or an increase that shocks the economy into a recession, or creates a banking crisis. Banks did not benefit from Volcker’s hike, which created the money center banking crisis that lasted over a decade.

        This situation has a lot of nuance that simple correlations aren’t going to capture, nevertheless I think the banks are correct here and are not just channeling cultural preferences for hard money.

        1. ..and according to this crude model, a 1% hike in FF will increase bank profits by about $36 Billion, and this number will grow with GDP, so it makes sense that banks want to normalize rates as quickly as possible.

  10. Sorry another comment. I am no expert and so have no clue what the answer is, but it’s a fascinating question and debate.

    A question I would have about the relative profitability of banks in low and high rate environments is the relative size and income of banks in those two environments.

    For example in 2006 and 2007, there were many more banks and much more employment in that high rate environment. After 2008 when rates went to zero many banks either vanished or were forcibly merged with other banks. Employment dropped off. Wachovia. WaMu. Indybank. AIG. Fannie and Freddie. Lehman. Bearn Stearns.

    Of course there are questions of government subsidies, oligopolies for the big banks and competition for smaller banks.

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