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Slow loan growth hitting CD rates?

By Claes Bell ·
Monday, April 25, 2011
Posted: 4 pm ET

This month, banks are reporting their first-quarter earnings, and while many banks are reporting healthy profits, those hoping for higher CD rates in the near future should be worried about the persistent lack of loan growth across the industry. From Joe Rauch at Reuters:

Investors looking for loan growth and surging revenues at the biggest U.S. banks, including Citigroup, are likely to be disappointed by first-quarter earnings.

Banks have been generating most of their profits in recent quarters from dipping into money they previously set aside to cover bad loans. Those reserve reductions make sense if credit losses are stabilizing, which seems to be the case.

But banks cannot reduce their loan loss reserves forever, and at this point, profit growth must come from making more money from loans and generating more fees, analysts said.

Boosting interest income from loans is tough when the interest rates at which banks lend are so low and loan demand is still tepid.

So why should CD investors care? Well, loan demand plays a prominent role in how banks set CD rates.

Think of the total amount of funds a bank needs to operate as a glass, and the funds they have on hand as the water. There are basically two ways banks can fill the glass: taking deposits or borrowing. Either way, filling up that glass costs the bank money in the form of interest paid, marketing, administration and other outlays, known collectively as the cost of funds. The bank's goal is to keep that glass full at the lowest cost of funds possible.

The cheapest funds for banks are checking account deposits, since banks pay little to no interest to checking customers, and they take up a substantial portion of the glass' volume.

The next cheapest funds come from liquid savings accounts, which earn only modest interest. CDs, with their higher rates of interest, go on top of liquid savings. Any room left over in the glass is filled up by borrowing from other banks in the short term, or from large regional "banks for banks," called federal home loan banks, in the medium- and long-term.

The problem for CD investors is, right now, the glass banks have to fill is pretty small because demand for loans is still weak. On the commercial lending side, many businesses are facing weak customer demand themselves, and so don't need to borrow money from banks to expand. On the consumer side, many are still unwilling or unable to borrow because of aftereffects from the credit and housing bust that followed.

Meanwhile, checking and savings account balances are taking up a larger amount of the glass' volume than usual. That's because many investors and businesses, still spooked by the financial crisis and the recession, continue to keep their money in FDIC-insured savings and checking accounts, waiting for the right time to invest. Between the smaller glass and the abundance of cheap deposits already filling it up, banks hardly need to open the CD tap at all to keep their glass full, which is why they're content to offer such lackluster yields.

Two things need to happen for CD yields to recover. First, demand for loans among businesses and consumers has to grow, which will make the banks' glass bigger. That extra volume means banks will have to raise rates to attract more CD investors.

Second, investors and consumers in general need to put the money currently languishing in checking accounts and liquid savings accounts to use either in investing or consuming more goods. That, too, will leave more room in the glass banks will have to turn to CD investors to fill.

Unfortunately for CD investors, neither of these things appear to be happening right now.

What do you think? Will CD rates start coming back anytime soon, or will we have to wait for 2012 to see decent CD rates?

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