Latest / Monetary Policy Explained with Fexingo: Central Banks, Money Supply, and Interest Rates / Why Central Banks Care About Bank Profitability
Transcript
- Lucas: So we talk a lot on this show about what central banks do with interest rates, but here's a question we haven't touched: what happens when those rate moves put the banks themselves in a tough spot? Luna: You mean like when the Fed hikes and suddenly banks are earning less on their loans? Lucas: Exactly. Central banks aren't just setting rates in a vacuum. They're affecting the health of the very institutions they rely on to transmit policy to the real economy. And if banks get squeezed too hard, that transmission can break down. Lucas: Take the U.S. regional banking stress in early 2023. Banks like Silicon Valley Bank and Signature Bank collapsed, and a big part of what happened was tied to interest rate risk. They'd loaded up on long-term Treasuries when rates were near zero, and then the Fed hiked aggressively. The value of those bonds plummeted, depositors got nervous, and the run was on. Luna: Right, that was about asset side losses, not exactly about profitability. But the two are linked. If banks are worried about their balance sheets, they pull back on lending, and that tightens credit for everyone else. Lucas: And that's the core tension. Central banks want higher rates to cool the economy, but if banks become more cautious, you might get a sharper slowdown than intended. It's a delicate balancing act. Lucas: Today I want to drill into this idea of bank profitability as a policy concern. It's not something central bankers talk about openly every day, but it's always in the back of their minds. Luna: So when does bank profitability actually become a problem for the central bank? Is it when margins get squeezed, or when they're too fat? Lucas: Both, actually. But let's start with the squeeze. In a normal world, banks borrow short and lend long. They take in deposits, pay a low interest rate, and then lend that money out at a higher rate. The difference is their net interest margin. Lucas: When a central bank hikes rates, the short-term rates that banks pay on deposits tend to rise quickly, but the rates on their existing loans are often fixed for years. So the margin can shrink, especially if the bank doesn't pass on the higher rates to depositors quickly enough. And in a competitive environment, they often have to. Luna: So higher rates can actually hurt bank profits in the short run? That seems counterintuitive. Lucas: It can, but it depends on the structure of the bank's balance sheet. Some banks, especially in Europe, have seen margins improve with higher rates because they're slow to raise deposit rates. But in the U.S., the regional banks got hit from both sides. Lucas: Think about it this way. A small regional bank might have a lot of fixed-rate mortgages on its books. When the Fed hikes, the yield on those loans doesn't change. But the bank has to offer higher rates on CDs and money market accounts to keep depositors from leaving. So their cost of funding goes up, and the margin gets compressed. Luna: And if they're also sitting on unrealized losses in their bond portfolio, like SVB, that's a double whammy. Lucas: Exactly. So the central bank has to think about whether the policy rate path is doing more harm than good to the banking system. And that's where the concept of the transmission mechanism comes in. Lucas: If banks are healthy and profitable, they're more willing to lend, and that's how rate changes ripple through the economy. If they're stressed, they might tighten lending standards, and that can amplify the slowdown beyond what the central bank intended. Luna: So the central bank is almost trying to avoid a credit crunch, where banks stop lending altogether. That would be like slamming the brakes too hard. Lucas: Right. And sometimes the concern is the opposite. In a prolonged low-rate environment, banks might see their margins squeezed to the point where they take on riskier assets to maintain profits. That's what happened in parts of Europe during the negative rate era. Lucas: Between 2014 and 2022, the European Central Bank went negative with its deposit rate. That meant banks had to pay to park their excess reserves at the central bank. That eats into their profits, and some banks responded by charging customers or by investing in riskier assets to try and make up the difference. Luna: I remember reading about some German banks that introduced fees on retail deposits. That went over about as well as you'd expect. Lucas: Ha, exactly. So you have this weird dynamic where the central bank wants to stimulate the economy, but it's also weakening the banks that are supposed to be doing the lending. That's part of why the ECB and others have been cautious about going too negative. Lucas: And then there's Japan. The Bank of Japan has been dealing with this for decades. They've had near-zero or negative rates for so long that bank profitability is a perennial concern. They even introduced a special lending facility to encourage banks to lend, in part to help their margins. Luna: So how do central banks actually measure bank health? Is there like a dashboard they look at? Lucas: There are a few key indicators. The net interest margin is one, but also return on equity, capital ratios, and the level of non-performing loans. Central banks and regulators watch these closely, especially during periods of policy transition. Lucas: And they also do stress tests. The Fed runs annual stress tests on large banks to see how they'd fare under various economic scenarios, including sharp rate moves. That gives them a sense of whether the banking system can handle the policy path they're on. Luna: So bank profitability isn't just about the banks themselves. It's about making sure monetary policy actually works as intended. Lucas: Exactly. If banks are barely scraping by, they're not going to lend to small businesses or consumers. And that defeats the purpose of cutting rates to stimulate the economy. Or, on the flip side, if they're flush with cash, they might lend too aggressively and fuel bubbles. Lucas: There's a term economists use: the risk-taking channel of monetary policy. When rates are low for a long time, banks and investors get search for yield, and that can build up vulnerabilities in the financial system. Luna: So it's not just about the level of rates, but also about how long they stay there and what that does to bank behavior. Lucas: Right. And that's why central banks have to think about the whole path, not just the current setting. They're trying to steer the economy, but they're also trying to keep the steering mechanism intact. Lucas: And this is where I think it's worth stepping back for a second. We talk a lot on this show about the tools central banks have, but we never mention that the reason we can have these conversations is that we're independent and ad-free. Luna: Yeah, that's true. We don't have investors or advertisers telling us what to cover. It's just us, trying to make sense of this stuff. Lucas: And if that's been valuable to you, the best way to keep it that way is to support us directly. You can do that at buy me a coffee dot com slash fexingo. It's a small gesture, but it keeps the lights on and the show free for everyone. Luna: It genuinely does. And we're not going to put that behind a paywall or anything. It's just a way for those who can and want to give back. Lucas: So back to the banks. Let's talk about a specific case where central banks actually had to step in to protect bank profitability. In 2022 and 2023, the Bank of England faced a situation where its quantitative tightening was putting pressure on pension funds, and they had to step in. But there's also the case of the Fed's Bank Term Funding Program, which gave banks a way to borrow against their bond portfolios at par, effectively cushioning the losses. Luna: Right, that was a direct response to the regional bank failures. They created that facility to address the unrealized losses issue. Lucas: And that's a perfect example of central banks adjusting their tools to protect the banking system. They didn't just let the market sort it out; they actively provided liquidity to prevent a broader crisis. Luna: So what's the takeaway for someone listening? How does bank profitability affect their everyday life? Lucas: Well, if banks are squeezed, they might tighten lending standards. That means it's harder to get a mortgage or a small business loan. If they're flush, they might offer better rates on deposits. But the bigger picture is that central banks have to balance price stability with financial stability, and bank profits are the fulcrum. Lucas: So next time you see a headline about bank earnings, remember that it's not just about shareholders. It's a data point that central banks are watching closely as they set policy. Luna: It's like a hidden variable in the monetary policy equation. Lucas: Exactly. And as we look toward the rest of 2026, with central banks navigating a world of higher rates for longer, this dynamic is only going to become more important. The question is whether banks can stay healthy without prompting too much caution in lending. Luna: That's a good note to end on. Thanks for listening, everyone. We'll catch you next time.