If you can think of one type of business that always has money, what would it be? Chances are, you’re thinking about banks. That same concept is why so many people feel comfortable investing in big banks like Bank of America. While that may be a good idea most of the time, now is not the time for big banks. Here’s why…
Where A Big Chunk Of Big Bank Revenue Comes From
Big banks make money in several ways. However, a massive chunk of their revenue comes from loans. More specifically, it comes from interest on loans. This is where the problem comes in. You see the Federal Reserve plays a big role in the interest banks charge. While the Federal Reserve doesn’t dictate the exact amount of interest banks charge, they do play a key role. Here’s how it works…
The Federal Reserve charges what’s known as the federal funds rate. That’s the rate the banks must pay to borrow money. When banks loan that money to consumers and businesses, they mark up the federal funds rate. This mark up allows the banks to earn a profit. However, banks generally have a percentage markup. Therefore, their overall profits from loans are heavily reliant on the Federal Reserve’s rate. Think about it, let’s say that the banks mark up the Federal Reserve’s rate by an average of 1,000%. Currently, the Federal Reserve’s rate is 0.25%. Therefore, at the fictitious mark up above, the banks would charge 2.50%; leaving the banks 2.25% interest as profit. However, if the Federal Reserve decided to increase it’s rate to 0.75%. Using the same mark up, the banks would charge 7.50%. After paying the Federal Reserve their 0.75%, the bank would keep 6.75% interest as profit. So, when the Federal Reserve’s rate is higher, big banks make far more money on loans.
The Big Problem For Banks!
The big problem for banks at the moment is that the Federal Reserve’s rate is so low. In fact, the 0.25% rate we’re currently seeing is the lowest in history! However, big banks and their investors were excited by the Federal Reserve’s plans to increase it’s rate by the end of the year. As a result, investors have held bank stock prices higher than they normally would. Now the problem is the fact that it doesn’t seem like the Federal Reserve is likely to raise its rate by the end of the year. The reality is that to raise the rate, the Federal Reserve needs to know that the US economy can withstand the pressure. However, the US economy isn’t looking good.
In fact, there are a few major issues with the economy at the moment. First and foremost, consumer spending is a major factor in economic growth. However, consumer spending has been moving at an incredibly slow rate. This puts quite a bit of pressure on the economy. Another major factor is that exports are struggling. Essentially, the United States economy needs money coming in from elsewhere to grow. That happens through exports. However, with the strong US dollar that we’ve been seeing throughout the past year, US products have grown in price abroad. This has caused a decline in demand for these products and put the pressure on US companies. Finally, jobs growth is starting to decline in a big way. As a matter of fact, August and September proved to be a big miss in that sense; and economists aren’t expecting any major improvements in October.
As a result of all of these issues, the Fed is not likely to raise it’s rate and big banks are likely going to continue taking in less revenue from loans. So, until this changes, big banks simply aren’t the right place to invest.
What Do You Think?
Where do you think big banks are headed and why? Let us know in the comments below!