Philadelphia Reflections

Gloomy Future for Banks

Banks pay depositors modest interest rates, lending to borrowers at higher ones. This is known as lending long and borrowing short.

One of the many Joseph Nicholson's in Philadelphia once surprised me by criticizing Paul A. Volcker as merely a tool of the banks. That distinguished Chairman of the Federal Reserve had always been, and still is, one of my heroes for rescuing the nation from inflation. Instead of wringing his hands at inflation, Volcker had the courage to jolt short-term interest rates right up to 8%. It must have caused a lot of pain to some people, but in retrospect, it was exactly the right thing for him to do. How could anyone complain about his helping the banks when he was helping the world economy for everybody?

The answer is that the old Quaker felt 8% was too little, Volcker should have gone higher. In fact, banks always have comparatively little at stake in whether interest rates are high or low. Their profit lies in maintaining a steep yield curve. Which is to say, as long as short-term rates are safely lower than long-term rates, the banks make a profit. It may be hard to recollect, but typical interest rates facing Volcker were then about 18% for long-term loans. Joe Nicholson had a point when he complained that a 10% profit seemed too generous, but for Volcker to raise short term rates to say 15% would have been seen as the act of a madman. In fact, 8% did turn out to be adequate for curing inflation, so this episode had a happy ending for both inflation and bank profits. Borrowers commonly feel that banks are greedy, but remember they must accumulate reserves. If the yield curve becomes "inverted" for a protracted time (that is if ninety-day rates are higher than ten-year rates) refusing to make loans is the only alternative to spending reserves. If that fails there can be bankruptcy, usually triggered by runs on the bank by depositors in a panic.

Long term rates are set by the bond market, short term rates are set by the Fed. This limits the traditional ability of the Federal Reserve to sustain the viability of banks to one simple tool, keeping short term rates below whatever rates the bond market sets for long loans. In recent years, however, banks have a new competitor for deposits in the form of money market funds. The new formula for what banks want in their Christmas stocking is for the Federal Reserve to set short-term rates well below the market-set rate for long-term rates; but mind you, only slightly below the market-set rates for money market funds. Caught between these two implacable limits, the Federal Reserve has a small room for safe maneuver. It is disquieting to hear that fluctuations of market-set interest rates are very difficult if not impossible to understand. Alan Greenspan called them a "conundrum".

And so, when you see pictures of the Federal Reserve Chairman riding off in a long limousine, he may look fully equal to the responsibility of keeping the world from financial collapse. Someone on the sidewalk once muttered that a man with a beard always looks like he's hiding.

Originally published: Thursday, December 20, 2007; most-recently modified: Tuesday, May 21, 2019