To understand this, we need to look at the macroeconomic environment. The interest rate has been falling for about 40 years. This is so long that few in finance or economics today were working back when rates were rising. Falling rates is presumed to be normal.
Normal or not, it puts growing pressure on the profit margins of every enterprise, including banks. When the interest rate was 10 percent, a bank could make a wide spread between what it pays to borrow and what it earns to lend. But this spread narrows as the rate falls. So, banks have two responses.
One is to increase their leverage. Suppose a bank takes in $1,000,000 in deposits. If it lends $900,000 (or buys $900,000 assets), then it keeps $100,000 in cash. If the bank is paying 6 percent on average for its deposits, then its cost is $60,000. If it is lending at 10 percent, then it is making $90,000 on the part it lends out (and to keep it simple, assume nothing on the part it keeps). The difference between the two is the bank's gross margin, or $30,000.
But if the interest rate falls, and the bank is paying 0.75% and lending at 2%, the math changes. Its cost would be $7,500 and its revenues $20,000. So, its gross is now $12,500. Let's assume that the bank employs the same number of people, and pays rent on the same square footage of retail bank branches to raise deposits as it did (the cost of compliance is actually much higher today). The bank has a big shortfall to somehow make up.
So, the bank may be tempted not to lend just $900,000 but, say, $990,000. By lending that additional $90,000, it adds $1,800 revenues. So, it is up to $14,300. Better, but still inadequate.
The other trick is to lend for longer duration. The interest rate is normally higher on long bonds than it is on short-term bills (though we have had some inversion in recent months). Suppose the 30-year bond yield were 3.25% (it's actually a point less right now). On $990,000, the bank earns a gross of $32,175, or a net margin of $24,675. That looks better, doesn't it?
Of course, there are macroeconomic problems when a bank lends a higher percentage of deposits. The borrowers spend those dollars, and in an irredeemable currency system, there is no way to hold a dollar outside the banking system (even the paper bank note funds the Fed, which funds the banks and the government). The recipients of those spent dollars deposit them in a bank. Which lends 99%. And so on. The quantity of what people call money goes up quite rapidly.
There are also risks to the bank itself. Depositors have the right to withdraw deposits, but the bank does not have the right to call its loans. So, if depositors want to withdraw cash, the bank may not have enough on hand. Then, it must sell assets and take losses, even in a good market. And in times of crisis, these losses are much greater.
And there will be a crisis, because the other banks are in the same situation. All attempt to sell assets, with few (or no) buyers, desperately raising cash to satisfy their creditors who are withdrawing cash and not willing to roll their credit.
) but they raise some troubling points.
