A steep yield curve should mean fat profits for banks. It hasn’t.

Unable to find qualified borrowers and worried that interest rates have nowhere to go but up, banks are stockpiling cash and securities while letting loans dwindle. It turns out banks won’t lend till rates rise. The trouble is, if rates rise their capital will take another hit, leaving them little to support new lending.

The yield curve is a proxy for the difference between short-term rates at which banks borrow and long-term rates at which they lend. In theory, a “steeper” curve means a wider profit margin.

As the following chart shows, bank profit margins aren’t keeping pace with the steepness of the curve.

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Why not? One issue is that banks aren’t lending. You can’t make money borrowing short if you’re not willing to lend long. Indeed, banks are shrinking their loan books while socking away cash:

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Why do this?

Cash is more liquid than loans, of course, so higher balances protect banks from the volatility of credit markets. Also, it prepares them for stricter liquidity requirements coming from regulators.

The fall in lending is more controversial, but banks are absolutely right to be curtailing loans. One reason, 10% unemployment means a dearth of credit-worthy borrowers. Another important one: Rates have nowhere to go but up.

A bank originating a new 30-year mortgage at 5.3% is taking significant interest rate risk. Remember, the bank has to borrow short to fund the mortgage, by selling CDs for instance. One year CDs average 1.6% according to Bankrate. Because rates can’t go lower, deposits are likely to get more expensive over the 30-year life of the mortgage. What looks like a healthy interest rate spread today (5.3% – 1.6% = 3.7%) is going to tighten.

The risk involved in originating new mortgages is a big reason the vast majority are now purchased or backed by Fannie, Freddie or FHA.

Instead of loans, banks have been plowing assets into more liquid securities according to Paul Miller of FBR Research. But as credit markets have healed, the interest rate spread on these assets have also come down, limiting profit potential.*

When will banks lend again? Miller argues that “for any meaningful margin expansion…the Fed needs to raise rates.”

The yield curve may be steep, but it’s steep at low rates. Banks can’t capture the whole spread because they have to pay significantly more for deposits than the Fed funds rate of 0-0.25%. To make money, banks need to lend at higher rates.

Also many carry floating assets – credit card and corporate loans, ARMs – that key off indices like LIBOR. A Fed hike would instantly improve their yield.

Trouble is higher rates mean lower real estate prices and higher default rates, which will continue to bleed bank capital. It’s a troubling paradox: Banks can’t make money on new lending without higher rates, but higher rates will increase credit losses on old legacy loans. It’s another reason the Fed is stuck.

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