Sunday, May 10, 2009

How banks plan to survive

The banks have a survival plan and the Fed and Treasury seem to be on board. It looks like this. They are going to earn their way out of trouble. Sure, the capital they have now is probably not truly there if they really took all the marks that they should. But they will write it down slowly over the next few years and replace it with earnings.

They think they will be able to do this because of a few things

  • High interest rate spread. Their deposit cost is very low due to the Fed's zero interest rate policy.
  • They can raise interest rates on loans.
  • They can borrow cheaper in the capital markets because the government is guaranteeing their debt

Now lets look at these in detail to show how all of them are direct wealth transfers from individuals and businesses to the banks.

First, the Fed's zero interest rate policy (ZIRP), forces deposit costs down. People with money in the bank are now getting 0.25% or something instead of 3% or so that they were getting a few years ago. This punishes seniors and other savers including businesses with large cash balances. This results in about $200 Billion dollars per year of interest income getting shuffled from the savers back to the banks.

They can raise rates on loans. They are already doing this. Here are a couple links from the New York Times and ABC News talking about how they are increasing credit card rates on people with good credit. Why are they doing this? Simply because they can. The right question is why didn't they do this in the past. Well, the credit card business is very competitive and people frequently do balance transfers to get better rates. But in this deleveraging environment, no one wants new credit card customers. They would love it if their customers paid off their balance and dropped off the face of the earth. They are not growing these portfolios. They are trying to reduce them. So it is an easy problem for them. Raise rates and fees through the roof. Either you pay them and make them lots of money or you pay off your balance and they reduce their leverage and so reduce the amount of capital they need to raise.

How much does this get them? Well, there is $2.5 Trillion in US consumer debt. If they can raise interest rates (or fees) by 5%, that is $125B/year in extra income. And that is just consumer debt. Total household debt (minus consumer debt) is about $11.5 Trillion and there is another $7 Trillion of non-financial corporate debt. Banks owns about $5 Trillion of this. If they can squeeze another 2% interest rate out of that $5 Trillion, that is $100B/year. Again, if the borrowers don't like it, they can try to find a loan elsewhere. If they leave, the bank has successfully delevered. So raising interest rates on borrowers might get another $225B/year.

Finally, there is all the government guarantees on their debt and direct government lending. I won't estimate the impact on earnings other than to say that without it, they would probably cease to exists. Certainly the Wall Street "banks" would have failed just as Bear Sterns did without the access the discount window and other such programs.

So the impact of lower deposit cost and high interest rates creates a much larger spread which might be roughly $425B/year in extra income for the banks. This is money that is transfered from US individuals and businesses directly to the banks. Most estimates of US banks losses is around $1 Trillion. So the banks can replace this capital through higher interest income is roughly two years.

In summary, the Fed and the government have orchestrated a massive wealth transfer in favor of the banks. This, of course, is in addition to Federal bailout of the banks through the TARP and other such programs. The banks are able to so this because they have essential control over the US government and have power over the central bank with its ability to create money and determined interest rates that banks have to pay for deposits. The banks will probably survive and replace this $1 Trillion capital hole with our money but ownership of the banks will largely remain in the same hands.

There is perhaps a bigger point to be made here. Banks are really intermediaries between borrowers and lenders. They don't produce anything. When you deposit money in a bank, and your neighbor gets a mortgage from that banks, it is really you lending to your neighbor. The bank is a useful intermediary. It performs credit analysis and protects you (with final backstop from the FDIC) from losses. For this service, it collect a fee. But the fee that is collected is a cost to the greater society, i.e. the real economy. The economy therefore is better off with banks being less profitable. Large bank profits, result in capital piling up at the bank which leads to a need to produce more and more credit. This obviously leads to a credit bubble and a crisis when it collapses. At the top of the bubble financials produced 40% of all corporate earnings, without producing anything. This is up form the long term average of about 15%. Those bank earnings which could have been income or industrial earnings would have resulted in a stronger US economy. Instead we had a credit bubble. The lesson is that the banks should not be the dominant force in an economy. They should be the oil that greases the wheel not the wheel itself.