The Smaller Banks And Rising Interest Rates

The "sure" bet over the past year or so has been that the Federal Reserve would keep short term interest rates as low as they could for a long time.

In fact, the Fed told us they would keep short term interest rates low for "an extended period" of time, guaranteeing speculative bets on interest rates.

Long term interest rates have also been "low" during this time as liquidity splashed over from the shorter end of the financial markets to the longer end.

However, the spread between long term interest rates and short term interest rates have been very, very nice for a lot of investors and certainly, the bank regulators have not been displeased by the interest rate spreads that have been available to investors, particularly commercial banks and other financial intermediaries who have been able to build up profits to strengthen their institutions.

This spread has been nice for profits but this was not exactly all that the Federal Reserve wanted throughout this period of quantitative easing. In fact, the Fed was very clear that one of the main reasons it was engaged in quantitative easing was that by flooding the financial markets with liquidity, longer term assets, which under other circumstances proved to be very illiquid, could be disposed of when the markets were in a much more fluid situation. The banks were supposed to sell off a lot of their long-term or less-liquid long-term securities.

Furthermore, this would ease the pressure of "mark-to-market" accounting on the banks since such sales at prices closer to purchase value would allow the banks to escape the need to write down other, similar assets even though there was no intent on the part of the banks to sell the securities in the near term.

The larger commercial banks in the system took advantage of this interest rate spread in the earlier stages of the recovery to generate healthy profits and get themselves back on the way to greater solvency, with reduced regulatory oversight.

Then, the larger banks moved on to other things, once the regulators backed off and government money was repaid. The biggest banks are not nearly as mismatched as they were two years ago.

In my opinion, the interest rate policy of the Federal Reserve did more to help the biggest banks regain their "mojo" than did any other part of the bailouts. The Fed's policy was a grand subsidization program carried out under the cover of helping to get the economy moving again.

The smaller banks, however, have not prospered from the quantitative easing. The maturity mis-match has allowed these smaller organizations to counter some of the enormous losses in commercial and residential mortgages they had to absorb.