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A Real Stress Test for Regional Banks

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Net interest margins are most important indicator of sustainable financial-system strength.

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Yesterday on the Buzz, Professor Udall asked about regional banks and the impact a change in mark-to-market accounting would have on net-interest margins.

As the FDIC's Quarterly Banking Profile reveals, contrary to public perception -- and despite heroic efforts to bring down short-term interest rates -- net-interest margins are declining, not expanding.

A big reason for this is that the yields on bank investment and loan portfolios have fallen far faster than deposit rates. And contrary to many opinions out there, I don't think the Fed is helping matters by pressing Treasury yields to lower and lower levels. Deposit rates aren't moving a whole lot - and a huge part of this is that deposits tend to be priced by the worst competitors in the market. And candidly, zero remains a very effective floor - no matter where Treasury yields are or are not.

Between what the Federal Reserve has done to distort the yield curve, the TARP, and the likely reforms to mark-to-market accounting, the regulators and the accountants are effectively "begging" banks to sell anything with a gain in it. While in the short run, this will generate capital, future net-interest margins will only be pressured more (as banks can only deploy the sale proceeds at lower rates). Worse still, banks are responding to margin pressure by raising borrowing costs (through embedded absolute-rate floors) in many floating-rate commercial loans.

Now, many believe that the FDIC guaranteed-funding program will make a difference. And while at the margin, that may be true (particularly for the brokers). At $250 billion (drawn to date) and $750 billion authorized, the program is tiny compared to the almost $7 trillion in deposits that are out there. From my perspective, until the FDIC puts a cap on deposit rates, margins will suffer.

And one final comment on net-interest margins: Contrary to what most think, from my perspective, net-interest margins - not credit losses - may be the most important indicator of sustainable financial-system strength. To me, net-interest margins represent systemic lung capacity and the ability of the system to breathe, as for most banks, credit losses and expenses are covered out of margin.

Until margins expand, banks' ability to withstand losses on their own is severely limited. And as I offered above, I'm afraid that banks are about to trade immediate capital for long-term earnings, only exacerbating our problems.



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