Don't Touch the Yield

There's a widespread idea in finance and economics land that there's something wrong, dangerous, even unnatural about persistently low interest rates.

This idea takes its perhaps most reasonable form in arguments that the fundamental cause of the Great Financial Crisis was rates that were "far too low for far too long," and that continued low interest rates, going forward, will only encourage speculation and new asset bubbles. Behind, or anyway alongside, these kinds of claims is a more fundamentally ideological view, that owners of financial assets are morally entitled to their accustomed returns, and woe betide the society or central banker that deprives them of the fruit of their non-labor. You hear this when certain well-known economists describe low rates as the "rape and plunder" of bondowners, or when Jim Grant says that the real victims of the recession are investors in money-market funds.

I want to look today at the "reaching for yield" version of this argument, which Brad Delong flagged as PRIORITY #1 RED FLAG OMEGA for the econosphere after it was endorsed by the Federal Reserve's Jeremy Stein. [1] In DeLong's summary:

Bankers want profits. ... And a bank has costs above and beyond the returns on its portfolio. For each dollar of deposits it collects, a bank must spend 2.5 cents per year servicing those deposits. In normal times, when interest rates are well above 2.5 percent per year, banks have a normal, sensible attitude to risk and return. They will accept greater risk only if they come with returns higher enough to actually diminish the chances of reporting a loss. But when interest rates fall low enough that even the most sensible portfolio cannot reliably deliver a return on the portfolio high enough to cover the 2.5 cent per year cost of managing deposits, a bank will "reach for yield" and start writing correlated unhedged out-of-the-money puts so that it covers its 2.5 percent per year hurdle unless its little world blows up. Banks stop reducing their risk as falling returns mean that diversification and margin can no longer be counted on to manage them but instead embrace risks. 

It is Stein's judgment that right now whatever benefits are being provided to employment and production by the Federal Reserve's super-sub-normal interest rate policy and aggressive quantitative easing are outweighed by the risks being run by banks that are reaching for yield. 

Now on one level, this just seems like a non-sequitur. "Banks holding more risky assets" is, after all, just another way of saying "banks making more loans." In fact, it's hard to see how monetary policy is ever supposed to work if we rule out the possibility of shifting banks' demand for risky private assets. [1] An Austrian, I suppose, might follow this logic to its conclusion and reject the idea of monetary policy in general; but presumably not an Obama appointee to the Fed.

But there's an even more fundamental problem, not only with the argument here but with the broader idea -- shared even by people who should know better -- that low interest rates hurt bank profits. It's natural to think that banks receive interest payments, so lower interest means less money for the bankers. But that is wrong.

Banks are the biggest borrowers as well as the biggest lenders in the economy, so what matters is not the absolute level of interest rates, but the spread -- the difference between the rate at which banks borrow and the rate at which they lend. A bank covers its costs as reliably borrowing at 1 percent and lending at 4, as it does borrowing at 3 percent and lending at 6. So if we want to argue that monetary policy affects the profitability of bank lending, we have to argue that it has a differential effect on banks funding costs and lending rates.

For many people making the low-rates-are-bad-for-banks argument, this differential effect may come from a mental model in which the main bank liabilities are non-interest-bearing deposits. Look at the DeLong quote again -- in the world it's describing, banks pay a fixed rate on their liabilities. And at one point that is what the real world looked like too.

In 1960, non-interest-bearing deposits made up over two-thirds of total bank liabilities. In a system like that, it's natural to see the effect of monetary policy as mainly on the asset side of bank balance sheets. But today's bank balance sheets look very different: commercial banks now pay interest on around 80 percent of their liabilities. So it's much less clear, a priori, why policy changes should affect banks interest income more than their funding costs. Since banks borrow short and lend long (that's sort of what it means to be a bank), and since monetary policy has its strongest effects at shorter maturities, one might even expect the effect on spreads to go the other way.

And in fact, when we look at the data, that is what we see.

Average interest rate paid (red) and received (blue) by commercial banks. Source: FDIC

The black line with diamonds is the Federal Funds rate, set by monetary policy. The blue line is the average interest rate charged by commercial banks on all loans and leases; the solid red line is their average funding cost; and the dotted red line is the average interest rate on commercial banks' interest-bearing liabilities. [3] As the figure shows, in the 1950s and '60s changes in the federal funds rate didn't move banks' funding costs at all, while they did have some effect on loan rates; the reach-for-yield story might have made sense then. But in recent decades, as banks' pool of cheap deposit funding has dried up, bank funding costs have become increasingly sensitive to the policy rate.

Looking at the most recent cycle, the decline in the Fed Funds rate from around 5 percent in 2006-2007 to the zero of today has been associated with a 2.5 point fall in bank funding costs but only a 1.5 point fall in bank lending rates -- in other words, a one point increase in spreads. The same relationship, though weaker, is present in the previous two cycles, but not before. More generally, the correlation of changes in the federal funds rate and changes in bank spreads is 0.49 for 1955-1980, but negative 0.38 for the years 1991-2001. So Stein's argument fails at the first step. If low bank margins are the problem, then "super-sub-normal interest rate policy" is the solution.

Let's walk through this again. The thing that banks care about is the difference between what it costs them to borrow, and what they can charge to lend. Wider spreads mean lending is more profitable, narrower spreads mean it's less so. And if banks need a minimum return on their lending -- to cover fixed costs, or to pay executives expected bonuses or whatever -- then when spreads get too narrow, banks may be tempted to take underprice risk. That's "reaching for yield." So turning to the figure, the spread is the space between the solid red line and the solid blue one. As we can see, in the 1950s and '60s, when banks funded themselves mostly with deposits, the red line -- their borrowing costs -- doesn't move at all with the federal funds rate. So for instance the sharp tightening at the end of the 1960s raises average bank lending rates by several points, but doesn't move bank borrowing rates at all. So in that period, a high federal funds rate means wide bank spreads, and a low federal funds rate means narrower spreads. In that context the "reaching for yield" story has a certain logic (which is not to say it would be true, or important.) But since the 1980s, the red line -- bank funding costs -- has become much more responsive to the federal funds rate, so this relationship between monetary policy and bank spreads no longer exists. If anything, as I said, the correlation runs in the opposite direction.

Short version: When banks are funded by non-interest bearing deposits, low interest rates can hurt their profits, which makes them have a sad face. But when banks pay interest on almost all their liabilities, as today, low rates make them have a happy face. [4] In which case there's no reason for them to reach for yield.

Now, it is true that the Fed has also intervened directly in the long end, where one might expect the impact on bank lending rates to be stronger. This is specifically the focus of a speech by Stein last October, where he explicitly said that if the policy rate were currently 3 percent he would have no objection to lowering it, but that he was more worried about unconventional policy to directly target long rates. [5] He offers a number of reasons why a fall in long rates due an expectation of lower short rates in the future would be expansionary, but a fall in long rates due to a lower term premium might not be. Frankly I find all these explanations ad-hoc and hand-wavey. But the key point for present purposes is that unconventional policy does not involve the central bank setting some kind of regulatory ceiling on long rates; rather, it involves lowering long rates via voluntary transactions with lenders. The way the Fed lowers rates on long bonds is by raising their price; the way it raises their price is by buying them. It is true, simply as a matter of logic, that the only way that QE can lower the market rate on a loan from, say, 4 percent to 3.9 percent, is by buying up enough loans (or rather, assets that are substitutes for loans) that the marginal lender now values a 3.9 percent loan the same as the marginal lender valued a 4 percent loan before. If a lender who previously would have considered a loan at 4 percent just worth making, does not now consider a loan at 3.9 percent worth making, then the interest rate on loans will not fall. Despite what John Taylor imagines, the Fed does not reduce interest rates by imposing a ceiling by fiat. So the statement, "if the Fed lowers long rates, bank won't want to lend" is incoherent: the only way the Fed can lower long rates is by making banks want to lend more.

Stein's argument is, to be honest, a bit puzzling. If it were true that banks respond to lower rates not by reducing lending or accepting lower profit margins, but by redoubling their efforts to fraudulently inflate returns, that would seem to be an argument for radically reforming the bank industry, or at least sending a bunch of bankers to jail. Stein, weirdly, wants it to be an argument for keeping rates perpetually high. But we don't even need to have that conversation. Because what matters to banks is not the absolute level of rates, but the spread between their borrowing rate and their lending rate. And in the current institutional setting, expansionary policy implies higher spreads. Nobody needs to be reaching for yield.

[1] The DeLong post doesn't give a link, but I think he's responding to this February 7 speech.

[2] As Daniel Davies puts it in comments to the DeLong post:

If the Federal Reserve sets out on a policy of lowering interest rates in order to encourage banks to make loans to the real economy, it is a bit weird for someone's main critique of the policy to be that it is encouraging banks to make loans. If Jeremy Stein worked for McDonalds, he would be warning that their latest ad campaign carried a risk that it might increase sales of delicious hamburgers.

[3] Specifically, these are commercial banks' total interest payments from loans and leases divided by the total stock of loans and leases, and total interest payments divided by total liabilities and interest-bearing liabilities respectively.

[4] Why yes, I have been hanging around with a toddler lately. 

[5] Interesting historical aside: Keynes' conclusion in the 1930s that central bank intereventions could not restore full employment and that fiscal policy was therefore necessary, was not -- pace the postwar Keynesian mainstream -- based on any skepticism about the responsiveness of economic activity to interest rates in principle. It was, rather, based on his long-standing doubts about the reliability of the link from short rates to long rates, plus a new conviction that central banks would be politically unable or unwilling to target long rates directly.