The high interest rate environment has been brutal for US banks

An analysis from the Financial Times suggests that the Federal Reserve’s aggressive rate-hiking campaign that started in March 2022 was a $1 trillion “windfall” for US banks, bolstering profit margins.

The thinking here focuses on one narrow part of how banks make money: the spread between what they pay depositors who want to park cash there and what banks can make risk-free.

I have a number of fundamental issues with framing the high-rate era as a boon for banks.

Guess what else happened as the Federal Reserve hiked rates? The value of bonds went down, since bond prices and yields move inversely. Guess who owns a lot of bonds? US banks!

The “risk free” returns banks were generating, in some cases, turned out to be quite risky, and, in some cases below the rates of financing deposits because of the inversion of the yield curve. Duration risk is A Thing.

The so-called “unrealized” losses on banks’ bond holdings played a big role in catalyzing what was primarily a regional regional bank crisis that began in March 2023. Banks that came under the most pressure were either in close geographic proximity to Silicon Valley Bank or, in the case of New York-based Signature Bank, had significant exposure to crypto. 

And while the FT claimed Fed hikes “helped pad out profit margins,” profit margins for the KBW Bank Index fell from 31.5% in 2021 to 23.1%. Pretty much every measure of banks’ financial performance — such as return on equity or return on assets — deteriorated from the end of 2021 through 2023 as the central bank tightened its policy rate.

Correlation is not causation, et cetera, et cetera, but let’s remember what the Federal Reserve was trying to do in taking its policy rate sharply higher: bring down inflation by slowing the economy. 

“While higher interest rates, slower growth, and softer labor market conditions will bring down inflation, they will also bring some pain to households and businesses,” said Fed Chair Jay Powell in his August 2022 speech at the Jackson Hole Economic Symposium.

Pain for households and businesses is not a good thing if your business is lending money to households and businesses. So the share of bad loans on banks’ books went up, and the money they set aside to account for more loans going bad did too.

And finally, the wisdom of the crowd also did not see this period as good for banks. The KBW Bank Index is still more than 20% off its early 2022 peak. The average S&P 500 stock has outperformed this bank index by nearly 30% since the Fed’s tightening campaign started. And only three of the KBW Index’s 25 members have outperformed the average S&P 500 stock over this stretch (JP Morgan, Goldman Sachs, and BNY Mellon). 

So…with “windfalls” like this, who needs penalties?