Speaking over a vast spectrum, banks operate under the concept of maturity transformation. In other words, banks take short-term financing vehicles, such as customer deposits, and use them to finance long-term returns.

These institutions make most of their profits through the interest spread between what they pay to the depositors and what is earned from the operations, but also through other services such as wealth management.

In terms of assets, the primary asset a bank holds is deposits. As these assets are owned by someone else, each of them demands a return for the use of those assets known as interest and cost of operation for the bank. A bank will then take assets and formulate loans on them.

Like most of the world, the US operates on a fractional reserve system, one where banks originate loans in excess of the deposits on hand. It is critical, then, that the bank convinces clients to keep their deposits undrawn by offering them interest on their money.

Causes of collapse

Therefore, interest stability becomes a problem. When the Fed manipulates interest rates, banks are able to forecast fairly steady expenses for operations. While a business likes it when operational costs are relatively constant, major problems for the banking system are created.

When interest rates are kept to near 0 per cent, the banking system builds up an income portfolio that is anchored to that near 0 per cent cost of operation.

Hence, any bank operating on fairly thin profit margins, relative to the bank's asset base, makes it highly vulnerable to any interest rate fluctuations.

Say the Fed begins to step up the target interest rate. As the Fed reduces competition on the market by selling assets, interest rates rise as there is more competition. If the risk-free rate starts to rise, depositors will look at a bank’s deposit return and be drawn to lower risk vehicles that are offering higher returns. This would cause banks to have to refinance short-term revolving debt at a higher rate.

The dilemma to the bank is that nearly their entire revenue stream is made up of fixed-return vehicles. If the effective spread between total costs and total revenue is minimal, the bank is likely to make losses. Since the bank had made loans with a fixed term with these extremely low rates in mind, it will take some time to rebuild a portfolio of higher interest rate loans and investments to offset this loss or the bank will seek to engage in high risk investments.

A bank lacks the flexibility normal companies have, as they have to retain cash ratios to facilitate depositor withdrawals. In order to maintain ratios, banks could be prompted to sell assets to take on additional loans.

Two-fold problem

Firstly, the primary assets are income generating, so for every asset sold there is a higher cash bleed and any new debt has interest expenses without a corresponding asset return.

Secondly, the assets have rates below market rate, so have to be sold at a discount.

Central banks will inevitably respond by trying to stabilise rates again, generally keeping rates below the last cycle's floor. Central banks, then, continually push the rates down until they run into a barrier that causes them to engage in radical monetary policy. A fitting example of this is Canada's pattern since 1980 - an ever downward sloping roller coaster.

How to avoid this

If banks didn't operate in a world of constant interest rates, an increase in rates wouldn't be an especially large problem.

If rates are fluctuating, banks naturally hedge against changes in interest rates. When they create rates at a higher level and rates decline, they will enjoy a higher average return to build a buffer for when rates rise again. Furthermore, if rates engage in natural fluctuation, banks would be hesitant to finance long-term loans using short-term vehicles.

This article was issued by Maria Fenech, Investment Management Support Officer at Calamatta Cuschieri. For more information visit, www.cc.com.mt. The information, view and opinions provided in this article are being provided solely for educational and informational purposes and should not be construed as investment advice, advice concerning particular investments or investment decisions, or tax or legal advice.