Try to Be Serious, the Fed Didn't Shrink Bank Deposit Rates

In recent weeks we’ve heard about banks reducing their loan exposure to oil producers. With prices of crude at levels not seen in years, banks are less willing to lend toward proven supplies used as collateral for loans.

Just the same, J.P. Morgan announced last weekend that it would broadly tighten lending standards. No one should be surprised by this. Presently a quarter of the U.S. economy is locked down based on decrees from politicians at local, state and national levels. These shutdowns signal reduced economic growth, plus they also represent long-term risk. Think about it. Politicians have in a few short weeks revealed the major damage they can inflict on economies in short order. Lending standards must reflect this reality. The economic landscape has been profoundly changed thanks to the rapid and sick-inducing imposition of political force that wholly surprised investors, lenders and workers.

Which brings us to the rates of interest banks are paying for deposits. They’ve been low for quite some time, and they’re lower now. These low rates have some blaming the Federal Reserve. Supposedly the low rates paid by banks on deposits are a consequence of the Fed’s rate policies. Those who make this argument are reversing causation.

Without excusing the fallacy-stalked individuals who populate the U.S.’s central bank for even a second, to blame them for low rates on deposits is the equivalent of a Washington Redskins fan blaming the scoreboard operator for the team’s losses over the years. In truth, the operator is just confirming what’s happening on the field. Just the same, the Fed is merely confirming with its funds rate how little risk banks are taking.

One obvious signal of the above truth is interest paid on reserves by the Fed and other central banks. That the Fed has been paying interest on reserves for years has excited monetarists, monetary fabulists, and other conspiracy theorists as evidence that the central bank has been restraining economic growth by giving banks an incentive to not lend. What a laugh!

Indeed, if we look back to just six weeks ago, the Fed lowered the rate it was paying banks to keep funds at the Fed to 1.1%. What that tells the partially awake is that for the longest time banks have been incredibly reluctant to lend to all but the surest of sure things. When they haven’t been able to find those kinds of lending opportunities, they’ve placed their excess at the Fed for a below-market return, but a return nonetheless.  

Crucial is that the Fed didn’t force this as much as it’s been providing the banks through which it projects its vastly overstated influence with a way to get some kind of interest paid on reserves when they can’t lend to certain bets. Again, the Fed just confirms reality as opposed to shaping it.

So why the incredible risk aversion among banks? One obvious clue would be 2008. Not only did the bailouts restrain the natural evolution of banking in much the same way that government propping up Friendster and MySpace would restrain social media’s evolution, those same bailouts also left us with myriad financial institutions shell-shocked by the past, and by extension, impaired by it. Having stared death in the face, they weren’t going to respond with aggressive lending that might bring them to death’s door again.

On the other hand, if banks had been allowed to fail then it’s not unreasonable to suggest that the failures could have been purchased on the cheap, along with their assets. The new owners, plainly not impaired by the past, could have taken bigger risks. If so, this would have reflected in their willingness to pay higher rates of interest on deposits.

Let’s never forget that at least when it comes to bank lending, and realistically any other business, it’s a spread game. Banks pay a rate of interest for deposits, and they do so because they have borrowers willing to pay them for access to the funds. The higher the interest rate charged to borrowers, the greater the borrower’s risk. Translated, the typical borrower of $10,000 from a bank would pay quite a bit more in interest on the loan than would Jeff Bezos.

So if banks were actually taking big risks with monies loaned out whereby they were charging high rates of interest, they would logically pay more for deposits. They would and could simply because the high rates of interest paid on their loans would earn them a comfortable spread even at higher rates paid on deposits.

That banks are paying very little for deposits right now is a reminder that this isn’t a Fed story as much as banks are once again extraordinarily risk averse, and have been for quite some time. To be clear, their headlong rush into home loans (formerly the preserve of vanilla S&Ls) in the 2000s was similarly a sign of major risk aversion despite what you're told. That’s why it’s so comical to read the commentary from the aforementioned monetarists, monetary fabulists and conspiracy theorists in which they claim the Fed’s payment of interest on reserves is holding back the economy. How could interest paid on reserves of the 1.1% variety exist as a reason for banks to cease actual lending in the marketplace?

The above question answers itself. The low rates paid by the Fed for reserves are a flashing indicator of how extraordinarily carefully banks are lending at the moment. That they’re being careful is a reminder of how little the Fed and the banks it supports have to do with economic growth.

Indeed, risk taking and other forms of intrepid capital allocation that foster surprising economic advances are what power growth, not loans to sure things. As evidenced by the willingness of banks to loan money to the Fed, banks are not presently in the business of intrepid, risk-oriented investing.

In short, the focus on the Federal Reserve as the source of low rates is just silly. Even sillier is the presumption that the Fed can stimulate growth through banks studiously avoiding all risk such that they pay very little to depositors. The Fed confirms bank credit conditions, as opposed to re-shaping them. Banks are presently only lending to the surest of sure things, and the Fed funds rate reflects this basic truth.