Will Banks Feel More Pain as Fed Keeps Rates Low Until 2013?

WASHINGTON — U.S. banks can expect more pain for the foreseeable future now that Federal Reserve Board officials opted to keep key interest rates at the same level for the next two years.

The Federal Open Market Committee on Tuesday agreed to keep the federal funds rate at a near zero level through mid-2013 saying they now expect a "somewhat slower pace of recovery" over the next several quarters than previously forecast.

The decision sparked a mixed review by Fed observers, with some suggesting such an unprecedented move would be an extension of the current environment while others said that it could ultimately have a negative impact on banks.

"If they think they're going to keep rates the way they are through 2013, the industry will be collapsing by then," said Chris Whalen, managing director at Lord, Whalen LLC's Institutional Risk Analytics. "They can't do it. They've got to let rates go up."

Some observers said an extended period of low interest rates will hurt earning assets for banks, which could potentially see net interest margins slip below 2%, according to Whalen.

"Do they think banks can survive with 2% or less? Cause the book is going to run-off," said Whalen.

Keeping a prolonged federal funds rate was a clear signal to the market that the Fed sees a definitive lack of improvement to the economy anytime soon.

"Banks do best when the economy is booming, and the Fed today said, 'We may be a few years away from rapid growth,'" said Jaret Seiberg, a Washington-based research analyst with MF Global. "I'm not sure banks were expecting boom times were around the corner, but it seems to suggest that it's a post-2012 event."

Others interpreted the Fed's decision as more of the same prolonged agony for financial institutions, who have shied away from making loans to consumers and small businesses.

"It continues to be the same environment that we've seen recently,' said Satish Kini, who co-chairs the banking group at Debevoise & Plimpton LLP. "The demand of bank lending will be muted, and therefore there will continue to be difficulty for banks that want to make loans and there will continue to be pressure on banks to do so."

In their decision, Fed officials noted that unemployment levels will continue to decline "only gradually" and pointed to an increase in downside risk in the U.S.' economic outlook.

"Economic growth so far this year has been considerably slower than the Committee had expected," the FOMC said in its statement. "Indicators suggest a deterioration in overall labor market conditions in recent months, and the unemployment rate has moved up. Household spending has flattened out, investment in nonresidential structures is still weak, and the housing sector remains depressed."

Not all members were on board with the Fed's decision to keep rates flat through 2013.

"It's hopeful," said Whalen. "I know internally there is a debate. I can tell you by the middle of next year regardless of what the Fed said today they are going to have to let rates go up."

The decision had three dissenting votes including Richard Fisher, Narayana Kocherlakota, and Charles Plosser, who would have preferred if the Fed kept its traditional language of keeping low levels for the federal funds rate for an "extended period."

Others, too, don't expect the Fed to maintain interest rates for that period of time given changes to the economy in the next two years.

"It's meaningless," said Allan Meltzer, a noted Fed historian and economist and a professor at Carnegie Mellon University's Tepper School of Business. "They no more know what they are going to be doing in 2013 than they know what they are going to be doing in 2020. It's going to depend on what happens to the economy between now and then whether they are going to stick to that."