How Banks Make Money When Rates Are Low

Posted on September 21st, 2016

Over the years, banks have experienced a metamorphosis from simple corner branches offering savings, checking and basic loans to mega financial entities offering investment products, mortgages, specialized lines of credit, investment banking and private banking. The dismantling of the depression era regulation, the Glass-Steagall Act, also known as the Banking Act of 1933, gave banks, insurance companies, and investment banks the ability to freely enter into a a variety of business functions simultaneously. Some economists believe that the loosening of these regulations that started in the mid 1990s may have led to the financial crisis of September 2008.

For years banks made money primarily from the interest earned on their loans and mortgages. This interest earned by banks is known as net interest margin, thus greater interest rates essentially earned larger net interest margins. This formula was fine for years until rates started to drop. So as rates dropped, banks were able to earn less of a margin, the difference between what banks pay the federal government to borrow funds versus what they lend it out for to both retail and institutional customers. As a result of the current low interest rate environment, banks are pressured to dig into different strategies to generate more return on the money the hold.

Many large banks have turned to investment activities in order to make up the shortfall, taking positions in financial markets in an effort to boost their bottom line. As a result of the extensive cash pools of large banks, buying or selling any financial instrument has a noticeable effect on the market, moving it one way or the other. Whether by design or not, the investment activities of banks has a severe effect on market participants without such large cash reserves.

This ability to push the market one way or another gives banks a tremendous advantage compared to individual investors, who end up jostled on the financial waves these big institutions cause. To survive amongst these behemoths, individual investors must have an adaptable investment strategy to ride out the market’s peaks and troughs in turn.

Sources: Federal Reserve, FDIC, Office of the Comptroller of the Currency