Back to top

Image: Bigstock

Here's the Downside of Monetary Policy Tightening for Banks

Read MoreHide Full Article

When the Federal Reserve had begun quantitative easing (QE) program in November 2008 and lowered the interest rates to near zero, the economy was in a mess with a significantly high unemployment rate, plummeting housing and financial markets, and lower consumer spending. The main goal was to stabilize the economy and spur growth, primarily by revitalizing the banks.

With the Fed injecting money into the economy, banks had more money to lend and earn from that. This liquidity infusion also fueled deposit growth. Over the years, major banks including JPMorgan Chase & Co. (JPM - Free Report) , Bank of America Corporation (BAC - Free Report) , Wells Fargo & Company (WFC - Free Report) , Citigroup Inc. (C - Free Report) and BB&T Corporation recorded a significant increase in their deposit balances.

As the economy was in shambles, lending activity failed to rise significantly. So, the banks were saddled with considerable amount of deposits. But with gradual economic recovery, loan demand improved. Along with this, banks witnessed a rise in deposits. So, they didn’t face much competition for attracting deposits to meet higher demand for loans.

As economy has stabilized and there seems to be no need for liquidity support, the Fed is gradually tightening its monetary policy. In December 2015, the central bank raised its interest rates for the first time in a decade. Since then, three more rate hikes have been announced.

Given the continued improvement in the economy, interest rate hikes will likely continue. With banks being one of the biggest beneficiaries of higher rates, this will support their revenue growth.

Moreover, last month, the Fed announced the timeline for commencing its balance-sheet (currently standing at a whopping $4.5 trillion) normalization program. Banks are likely to benefit from this as well. As the Fed buys back short-term duration securities, the yield curve will become steeper. This, in turn, will result in rise in the yield on long-term bonds and thus banks will gain from improved margin spreads.

While everyone is looking at the banks’ benefits from the Fed’s tightening monetary policy, there is a downside to it as well.

Increased Competition for Deposits

The Fed’s plan to unwind its balance sheet is expected to result in deposit outflows. Also, as the money supply in the economy will reduce, lesser amount will get deposited in the banks.

Such a scenario will lead to increased competition among banks to attract deposits. Similar sentiments are being echoed by top executives of major banks.

William Demchak, chairman and chief executive of The PNC Financial Services Group, Inc. (PNC - Free Report) , at an investors’ conference in September noted that competition for customer deposits could increase “partly as a result of the Fed draining cash out of the system by shrinking its balance sheet.”

Earlier in July at second quarter earnings conference call, U.S. Bancorp’s (USB - Free Report) chief financial officer Terrance Dolan said “…as excess liquidity comes out of the market you could expect to see and you will expect to see more competition with respect to deposits.”

Competition will likely be more intense for wholesale deposits — those coming from institutional clients and large companies.

Also, as the rise of online banking has made it easier from customers to switch banks and with the Fed expected to further increase interest rates, it will become easy for banks to offer higher rates on deposits. For customers stuck with persistently low deposit rates till now, banks providing higher rates on savings account will become more attractive.

Nevertheless, with economy improving gradually, deposits are expected to rise as well. Specifically, retail deposits are expected to rise driven by higher rates on deposits.

Overall, deposits are expected to continue increasing given the economic growth, though the pace of rise is likely to be slower compared with the QE period.

Of the above-mentioned major banks, JPMorgan, BB&T, Bank of America, PNC Financial and Citigroup carry a Zacks Rank #3 (Hold). You can see the complete list of today’s Zacks #1 Rank (Strong Buy) stocks here.

Can Hackers Put Money INTO Your Portfolio?

Earlier this month, credit bureau Equifax announced a massive data breach affecting 2 out of every 3 Americans. The cybersecurity industry is expanding quickly in response to this and similar events. But some stocks are better investments than others.

Zacks has just released Cybersecurity! An Investor’s Guide to help Zacks.com readers make the most of the $170 billion per year investment opportunity created by hackers and other threats. It reveals 4 stocks worth looking into right away.

Download the new report now>>