The Drawbacks of Banks' Free Money

By PETER EAVIS For banks, even free money may have its drawbacks. A key part of the bank-recovery story is that this interest-rate environment will let certain banks enjoy big margins on loan portfolios. The Federal Reserve's zero-interest-rate policy was expected to fatten those margins as banks funded themselves at low rates and lent at higher ones. Funding was going to get a boost at banks amassing new deposits, either from weaker rivals or through acquisitions. But the numbers suggest a less-compelling story. While margins have been respectable, they are hardly knocking the cover off the ball. Banks with over $10 billion in assets had a net interest margin, or NIM, of 3.21% in the first quarter, according to SNL Interactive. That is below 3.4% in the fourth quarter and under the 3.34% average since 2000. Banks perceived as strong aren't showing blowout NIMs, either. Wells Fargo's declined to 4.16% in the first quarter, from 4.7% in the fourth quarter, though some of this may be from buying Wachovia. Meanwhile, J.P. Morgan Chase's NIM rose only slightly, to 3.18% from 3.11%. The bank offset a big drop in its asset yield by reducing the cost of its liabilities by more. Banks often say it is better to watch net interest income in dollars, as well as margins. Yet J.P. Morgan's fell 3.4% in the first quarter. Wells Fargo's rose only 1.5%, excluding Wachovia, but soared nearly 70% with that acquisition. Granted, the first quarter may be a lull before banks start adding higher-yielding loans, causing higher margins and net interest income. Also, if the economy improves and fewer loans go bad, interest income improves because more borrowers can service debt. Another positive: Moribund securitization markets might allow banks to grab more business and price loans more profitably, said Gerard Cassidy, analyst with RBC Capital Markets. But Japanese banks' experience with zero-interest-rate policies suggests there are risks. When rates are unusually low, it is hard for banks with large deposits to maintain lending margins, because it becomes harder to cut deposit rates enough to fully offset declines in asset yields. Depositors typically want some return for keeping money in the bank. What's more, profitability gets further dented by the expenses of maintaining the branch network needed to collect deposits. This scenario is exacerbated if the yield on loans stagnates because banks can't find enough safe households and companies willing to borrow at rates that would create worthwhile margins. So far, talk about zombie banks has focused on the asset side of the balance sheet and loan losses. But Japan's experience suggests the liabilities also can put lenders in a quagmire. U.S. banks aren't there. But one thing is clear: Investors need to keep nitpicking the NIM. Write to Peter Eavis at peter.eavis@wsj.com