September 2003
Federal Reserve Bank of Dallas

The Impact of Low Interest Rates on Financial Institutions

This report briefly discusses the impact of low interest rates on financial institutions, focusing on concerns that further reductions in short-term interest rates could impair the profitability of banks and money market mutual funds and thereby affect the flows of finance from households to firms. These concerns have abated because medium and long-term bond yields have risen in recent weeks amid mounting evidence that the economic recovery is gaining steam. Nevertheless, short-term interest rates remain low and are having notable effects on money market mutual funds and banks, on which I will focus today.

The importance of banks to our financial system and economy is well recognized, but that of money funds is often less appreciated. To provide some perspective, retail money fund balances amount to about $870 billion or 14 percent of M2, and accounting for another $1,170 billion in institutionally held money funds, total money market mutual funds make up nearly 23 percent of M3, our broadest monetary aggregate. Money market mutual funds held about $2.2 trillion in assets at the end of 2002, including nearly $600 billion in commercial paper, which is nearly 44 percent of commercial paper issued by nonfinancial corporations and private financial firms. Money fund holdings of commercial paper amount to roughly 6 percent of total debt for financial and nonfinancial corporations, not much below the 9 percent share accounted for by nonmortgage bank loans. For this reason, it is important to consider both banks and money funds in assessing the impact of low short-term interest rates on financial institutions.

Effects of Low Short-Term Interest Rates on Money Market Funds
Money market mutual funds could encounter difficulties in paying positive interest rates to shareholders if already low market interest rates fell further. The reason is that they distribute their net earnings on their investments to account holders. In particular, money market funds pay interest rates equal to the return on short-term instruments, such as Treasury bills and commercial paper, plus any account fees minus account expenses. As short-term market interest rates approach zero, more funds would find it difficult to avoid paying negative interest, which in practice would mean passing a capital loss onto investors. This is important because a big appeal of holding money market mutual funds is their safehaven status in that fund investors have traditionally avoided the risk of capital losses. With short-term Treasury yields near 1 percent and money fund rates at around ½ percent, the margins at some funds are pressed because expense ratios at funds range from around 20 to 100 basis points. To some extent, slightly higher interest rates on their commercial paper and six-month Treasury holdings give money funds a little more elbow room. Nevertheless, a few smaller and less efficient funds have posted losses and a handful have even closed.

If short-term rates fell further, more money funds would encounter the zero bound and would face four options: bear losses, close, raise checking and wiring fees, or break the buck—that is expose shareholders to capital losses. Breaking the buck is a low probability option, since one appeal of money funds is their safe-haven reputation. If short-term rates fell much further, it is more likely that some funds would shut, raise fees or temporarily bear the losses. If markets expect short-term rates and economic growth to rise in the future, in which case the yield curve is steep (as it is now), then more funds may bear expected temporary losses until short-term rates rise. Many mutual fund families may do so because having a viable money fund enhances the appeal of their equity, bond and balanced fund offerings, thereby encouraging households to keep their assets within their particular mutual fund family.

Even if most money funds avoid the zero bound, money market fund balances are likely to decline at current low interest rates as households shift to other financial assets. As shown in Figure 1, there is a tight relationship between the target federal funds rate and the two-quarter moving average of growth in retail money fund assets. As short-term rates plunge, households can earn higher yields on alternative assets, some posing the risk of capital losses and some not. For example, they could shift out of money funds into bank savings deposits without facing potential capital losses. If short-term rates fell further, these substitution effects could become larger if some funds close, raise fees or break the buck. Indeed, in the last year and a half, M2 growth has remained strong as inflows into bank deposits have outweighed outflows at money funds.

Since money funds invest in commercial paper, money fund outflows could reduce the demand for buying commercial paper, thereby possibly pushing up commercial paper rates relative to bank loan interest rates and possibly pushing some commercial paper issuers out of the market. For two reasons the impact of such a shift in funding sources would likely be limited. First, commercial paper issuers are among the most credit-worthy firms and would be able to obtain financing by issuing bonds or equity, or by borrowing from banks, which would be flush with deposit inflows stemming from money fund withdrawals (Figure 2). Second, because firms typically use commercial paper or bank loans to finance inventories, any increased need to use these short-term funding sources going forward would likely arise from a strengthened recovery, which could eventually be accompanied by higher short-term interest rates that would bolster money fund balances. In recent years, commercial paper issuance by nonfinancial corporations has fallen largely as a by-product of firms’ cost-cutting efforts to reduce inventories.

Effects of Low Short- Term Interest Rates on Banks
While banks may enjoy deposit inflows if short-term rates continue at low levels or decline further, bank profits may not strengthen as much from a steep yield curve as in the past. Since banks borrow short-term funds from depositors and lend at a longer-run horizon, bank profits typically benefit from a steep yield curve, as depicted in Figure 3.

However, even though banks hold assets with a longer duration than money funds, banks are not earning as much from short-term accounts even though loan losses are under control. The reason is that interest income on many of their floating-rate loans falls with market interest rates, but deposit rates on short-term accounts are not falling by as much, as overnight rates get closer to zero and as the expense from managing accounts becomes relatively more important. Thus, as with money funds, bank profitability could be hampered under low short-term interest rates, though to a smaller extent than at money funds because banks can lend at longer horizons and to moderate risk borrowers.

Looking Ahead
Bond yields have risen during the summer as the risk of deflation has eased amid mounting signs that the economic recovery is gaining steam. Nevertheless, the recovery remains vulnerable to an unexpected negative shock and a resulting additional decline in inflation, which could spur further declines in short-term interest rates and their associated effects on banks and money funds. However, if short-term interest rates do not decline further, the impact of the current low level of interest rates on money funds and banks will likely not worsen much. In addition, any net impact on large firms would probably be limited, as they could shift away from issuing commercial paper toward tapping alternative sources of finance, such as bank loans, bond and equity.

Under this scenario, most money funds would skirt the zero bound, with money fund assets declining or barely growing until short-term rates eventually rise. Banks, in this case, would continue to see strong deposit growth, albeit with net interest margins not bolstered as much by the steep yield curve unless short-term rates eventually move upward. Nevertheless, how financial institutions, such as money funds and banks, will be affected by and react to low short-term interest rates in coming quarters will depend, in large part, on how economic activity and market expectations actually unfold.

—John V. Duca

About In Depth This article is based on a presentation by John V. Duca, vice president and senior economist in the Research Department of the Federal Reserve Bank of Dallas. The views expressed are those of the authors and do not necessarily reflect the positions of the Federal Reserve Bank of Dallas or the Federal Reserve System.