Low interest rates are suppressing bank profits in the short term and may be setting up stress in the long term. This is because interest rate cuts tend to reduce bank interest receivables faster than interest expenditures, causing credit spreads to tighten. Financial intermediaries, such as banks and credit unions, traditionally rely on interest rate spreads for profitability. The current so-called "low-for-long" policy era presents a major challenge for managers and investors in the financial sector.

Credit Spreads

Banks earn a profit on the difference between the lending rate and deposit rate. In a simple example, if JPMorgan Chase & Co. (JPM) charges 5% on all of its loans and only pays out 2% on its depositors' savings account balances, then JPMorgan Chase earns a 3% profit on the spread.

Now suppose the Federal Reserve cuts the target discount rate to 0%. It does this, in part, by buying lots of U.S. Treasuries and bidding up their price, which also lowers the yield. Now JPMorgan Chase can afford to reduce the amount of money it offers on its deposit accounts without fear of its depositors pulling their money out and putting it into government bonds. Lower Treasury yields also reduce the risk premium on all other assets, including bank loans.

As long as the interest rate charged on loans doesn't decline faster than the interest rate received on deposit accounts, banks can continue to operate normally or even reduce their bad loan exposure by offering lower lending rates to already-proven borrowers.

Recent Research

In April 2016, the Federal Reserve Board of Governors released a research paper that looked at bank profitability in Advanced Financial economies between 2005 and 2013. Their findings show that net interest margins (NIMs) get worse during low-rate environments, defined as any time when a country's three-month sovereign bond yield is less than 1.25%. The Fed's research concluded that "low rates are contributing to weaker NIMs."

In October 2015, the Bank for International Settlements (BIS) released a working paper on "The influence of monetary policy on bank profitability." Studying nearly 110 large banks in 14 advanced economies between 1995 and 2012, the BIS found that "over time, unusually low interest rates and an unusually flat turn structure erode bank profitability."

Borrower Risk

There's also the issue of counterparty risk. When a bank makes a loan to a customer, it is never 100% certain that the customer can make timely or full payments for all principal and interest. When central banks lower the interest rate, this move reduces the barriers for risky economic behavior. Companies or entrepreneurs that may have passed up an uncertain project at 10% interest may decide to roll the dice when the loan only charges a 3% rate. At the same time, borrowers of all stripes can afford to borrow proportionally more money relative to their income because the expense is lower. If a bank is not careful, it may find itself with a sizable increase in non-performing loans. This, in turn, compromises future profits.

Why Net Interest Margins Shrink with Low Rates

The reason a decline in market interest rates tends to exponentially reduce NIMs can be partially explained by how banks interact with the yield curve. For example, banks tend to lend money over a long period of time. For example, mortgages last for decades. However, when banks borrow, normally from other banks, they tend to borrow short. Initially, this serves to raise NIMs because the average maturity of the bank's assets exceeds the average maturity of its liabilities.

The problem is that eventually loans are repaid or renewed at lower interest rates. When rates get lower and lower toward the zero bound, the interest received from the bank's loan portfolio can keep falling, whereas it is difficult for banks to pay negative interest on a demand deposit account. In other words, bank liabilities hit their interest rate floor earlier than bank assets.