The prevalent low interest environment combined with fears of a looming economic slowdown are creating serious profitability issues for banks that focus primarily on the traditional loans & deposits model. While individuals as well as corporates are moving towards the safety of FDIC insured bank deposits due to the low interest rates and lack of high-return investment options, they are also shying away from taking on an additional loan burden in view of the impending fiscal cliff and uncertainty in the global economic outlook. As a result, banks are flush with cash and there are few takers. U.S. banks currently hold an excess of $2 trillion in deposits to outstanding loans.  To put things in perspective, outstanding loans exceeded deposits in these banks by $200 billion in October 2008.
The situation directly impacts banks’ net interest margins, as slowing loan volumes would bring in less interest income where as the swelling deposits will raise interest expenses. This would dent revenue figures for all banks with a sizable retail banking business, with the banks with a more risk-averse model like Wells Fargo (NYSE:WFC) and U.S. Bancorp (NYSE:USB) being hit the most. Incidentally, custody banks like BNY Mellon (NYSE:BK) and State Street (NYSE:STT) which perform the role of bankers for the banks would also be on the receiving end of the problem.
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The Low Interest Rates Are Necessary To Ensure Recovery
The Federal Reserve set interest rates at the 0 to 0.25% range in December 2008, and has maintained them at that level since. Last week, the Fed reaffirmed its stand of keeping rates at this level in the near future, until unemployment rates fall to below 6.5% and projected inflation levels are within acceptable limits. 
The rationale behind low federal fund rates is simple. When these rates are kept low, banks can afford to give out loans – be it personal loans, commercial loans or mortgages – at lower interest rates. This should coax individuals and companies looking for money to borrow, allowing the economy to slowly grow back to health.
But Not When People Turn Risk-Averse
The policy of cutting rates to help boost the economy would work if people maintain a stable outlook for the future. However, if the future looks uncertain as is perceived currently, the policy is rendered ineffective as people start saving and stay away from loans. The low interest rates actually make things worse, as investment options with decent returns dry up and bank deposits which offer some of the lowest returns under normal economic conditions start looking attractive. Even more so when the deposits are insured. People start parking their cash in banks, knowing that they don’t have a more secure investment option which pays better.
Banks Now Feel The Brunt
Having imposed a series of stricter guidelines regarding new loans to curb the size of poor quality loans in their portfolio, banks now find themselves with more cash than they can lend. Reports suggest that the banking industry is currently lending out 78 cents for every dollar in deposits.  And while all banks have seen a faster growth in deposits as compared to loans over recent months, State Street’s situation stands out both because of its operations as a custody bank as opposed to the other retail banks, and also because of the rate of growth in deposits.
Data compiled by the FDIC shows that the amount of deposits held by State Street branches at the end of Q2 2012 was $52.16 billion, nearly double the $28.61 billion reported in Q2 2011.  The trend indicates that not just retail customers, but also the institutional investors as well as other banks are storing money in deposits rather than looking for other investment options.
So is there something banks can do to stop the excessive reliance on deposits at least by large institutions? One of the measures that comes to mind is to impose charges on deposits exceeding a specific amount. This would in essence result in a negative interest rate for the deposit and should be enough to get a bulk of the investors thinking about moving their money. As radical as this sounds, both the Swiss banks UBS (NYSE:UBS) and Credit Suisse (NYSE:CS) have implemented this in recent years (see What’s The Story Behind Credit Suisse’s Negative Interest Rates For Deposits?).Notes: