Why A Mere Quarter Percent Rate Hike Should Have Big Banks Nervous But … – Seeking Alpha

Summary

Current excess reserves at the Fed earn interest.

The current profit stream that banks count on.

What happens when the fed funds rate rises by 25 basis points?

Conclusion: Poof!

Current excess reserves at the Fed earn interest

The big banks hold a lot of excess reserves at the Federal Reserve [Fed]. The current interest rate paid by the Fed on both required and excess reserves is 0.25 percent, or 25 basis points. The rate is subject to change by the Fed Board. No surprise that this policy was set forth in the Federal Reserve Regulatory Relief Act of 2006 which was scheduled to go into effect October 1, 2011. Also, no surprise was the advanced effective date of October 1, 2008 when relief for banks was imperative.

The current profit stream that banks count on

According to the St. Louis Fed, depository institutions (banks) held over $ 2.5 trillion in excess reserves at the Fed in November. At a mere 25 basis points in interest that $ 2.5 trillion in excess reserves earns big banks about $ 6.25 billion a year in risk-free revenue.

All of that amount may not go directly to the bottom line, though. How much depends upon what interest rate the Fed charges banks to borrow those funds (the fed funds rate). The effective fed funds rate has ranged between 7 basis points and 16 basis points over most of the last five years. The average borrowing rate of big banks since January 1, 2015 has been 12.27 basis points, or 0.1227 percent.

The banks have earned about $ 5.73 billion so far in 2015 on excess reserves. The cost to borrow those reserves has been approximately $ 3.07 billion. The net income earned from those borrowed reserves is $ 2.66 billion in 2015 thus far. That works out to an average of $ 725 million per quarter in extra earnings just for borrowing the money and leaving it parked at the Fed.

Now, this may not seem like much to you, but I would not mind getting in on that action.

What happens when the fed funds rate rises by 25 basis points?

Let’s be honest about the rate hike, okay? The current fed funds rate is officially set at between zero and 25 basis points. So, if the Fed raises the official fed funds rate to 25 basis point, if that is the actual outcome, then it really will not be raising the rate by a full 25 basis points. The increase will be something more like about 13 basis points over the actual rate since the beginning of the year.

Now, if the Fed raises the official rate to between 25 basis points and 50 basis points, then the difference could be closer to 25 basis points. But, it still depends on where within that range the actual fed funds rate lands. If it lands closer to the minimum of the range then the increase is more like 13 to 15 basis points. If it lands in the middle, then we have an actual increase in rates of about 25 basis points as advertised.

I do not really expect the actual rate to rise much, if any, above the 25 basis points threshold. So, my expectation is for a real rate increase of about 15 basis points. But that would mean that the earnings by the big banks could fall to zero. Somehow I do not expect the big banks to take this lying down.

I could be wrong, but I also expect another, less publicized change in rate policy by the Fed.

Conclusion: Poof!

If the fed funds rate increases to 25 basis points or more, then the “profits” earned by banks on excess reserves will evaporate into thin air and potentially turn into an expense. Unless…

If the Fed decides to raise the fed funds rate by 25 basis points to the range between 25 and 50 basis points the banks would either decide to reduce reserves (to avoid paying the Fed interest on borrowed funds) or the Fed would need to change the rate paid to depository institutions upward to 50 basis points.

Banks would need to put that money to work at a higher level of risk or just pay off the loans from the Fed used to fund reserves. Most likely some of the excess reserves would be withdrawn and banks would attempt to make up the lost earnings by adding more risk to balance sheets. More risk in the financial system is not something we need right now. I do not think the banks really want to take on more risk at the moment either. And since the banks own the Fed, guess which route I expect the Fed to take?

The one thing that would make banks nervous is if an increase to the rate paid on reserves is not raised along with the fed funds rate. I would expect a side deal to which all parties already agree. But I would not expect any publicity on this end of the deal. If there is no deal then the banks should be worried. Nearly $ 3 billion a year is nothing to sneeze at. And, if there is no deal, then we should probably be more worried about the banks and the financial system again.

In the end, I suspect that the fed funds rate will increase closer to 25 basis points, maybe 30. That would mean an increase of less than a full 25 basis points. On the other end I suspect that the rate paid to depository institutions will increase to 50 basis points. That would effectively increase the spread the banks realize and increase the net income by nearly $ 1 billion a year.

But, once again, if that rate paid on reserves does not increase the banks would lose. I could be wrong, but somehow I can’t help but think that the banks will win.

This is just the short-term portion of the equation as banks may also take a hit on the long-term end of things. Short-term borrowing costs will rise but that does not guarantee that the longer term Treasury rates will rise as much for the longer term. If long-term rates rise less it means that the yield curve could flatten, potentially providing lower profits to banks. But that is another discussion altogether.