Riding the Spread

Interest rates have gone up, and with them the cost of houses, cars, and other big-ticket consumer goods. It’s not just consumers who are feeling the pinch, though. Many banks are also finding it harder to make money in an environment of rising interest rates.

“Banks traditionally make their money on the spread they can get between what they pay on deposits and what they make on loans,” says Scott Anderson, vice president and senior economist for Wells Fargo & Company in Minneapolis. Those deposits come from consumer and business checking and savings accounts and certificates of deposit (CDs), as well as from the nationally brokered CD market.

Although the cost of funds is higher, banks also make money by borrowing funds—from a Federal Home Loan Bank, for instance—for the short term. They then either lend the cash to customers or invest it for the longer term in the national debt market. Deposits, too, are sometimes invested in longer-term bonds.

Seventeen rate hikes between 2004 and 2006 took the Federal Reserve's funds rate from 1 percent to 5.25 percent. The Fed has started to chip away at bank margins.

While interest rates were low, this business model put banks into “an unprecedented period of profitability,” Anderson says. “The Fed drove interest rates to the floor after the 2001 recession, and that meant that businesses and consumers were almost able to borrow for free, after you subtract inflation. There was a tremendous incentive for all kinds of borrowers to take advantage of that.” For banks, the cost of funds was low, and customers were eager to take out loans at prices that ensured bank profitability.

But seventeen rate hikes between June 2004 and July 2006 took the Federal Reserve’s (or the Fed’s) funds rate from 1 percent to 5.25 percent. With those increases, Anderson says, the Fed has started to chip away at bank margins. Rate increases and a slowing housing market have slowed the consumer demand for mortgages. Some banks, particularly those that aggressively wrote mortgages over the past five years, have been hurt by increasing foreclosures.