Low Interest Rates and Side Effects

I was recently at a bank as part of a non-profit (else I rarely step foot in a bank) when I was talking to the banker about setting up a new account and we started discussing the interest rates that each of the potential accounts would receive.  After a bit of discussion I said

At these rates, it doesn’t matter

Basically interest rates on savings accounts and non CD accounts are effectively zero unless you have an immense amount of money in that account.  For example, the Chase “savings” account offered .01% – which means that if you have $100,000 in the account all year long, you are going to make $100.  That is the definition of negligible.  Certainly you can shop around a little more and get a higher interest rate, but you aren’t going to get near 1% unless you buy some sort of vehicle with other conditions (i.e. locking up your money for a period of time).  The woman at the bank was apologetic but I knew that there was no reason for her to be – it wasn’t her fault that the nation had undergone a massive ZIRP experiment.

One side effect is that banks have now effectively become a vehicle for 1) making transactions 2) providing services.  They are no longer really a vehicle for making money (i.e. earning interest, especially compounded interest, that is meaningful over time).  Thus your money now is more of a way to avoid charges on those services (free checking, or avoiding low balance charges, or access to certain types of transactions without fees) than a means of making money.

The traditional function of banks is to take your deposits and turn around and “leverage” that money to make loans to others.  Since banks can count on not everyone to show up and demand their deposits back on the same day (unless there is a bank run), and they should be able to earn money on the difference between the cost of the money to them (they can borrow at the lowest rates) and what they charge loan customers, this should fund much of their profits.

The newspaper industry is dying because they provided journalism as a service but made their money selling advertising (effectively as a local monopoly for many years).  When businesses and individuals stopped buying advertising (hello, Craigslist), the “service” that they provide, journalism, had to pay the bills.  As a result this industry has gone into free fall since then.

Banks and many other financial institutions generally do a lot of services but make their money on the spread between what they pay you and what they pay for interest in terms of their cost of money.  Then they take that difference and it generally subsidizes everything else.  If that difference becomes negligible, then the financial institution has to make money in some other manner, or see their profits wither like the newspaper industry.

With interest rates so low and money washing into their doors, banks should be able to make up for everything on loans.  However, everyone is conservative about loaning money right now unless it is secured, and the home equity loan pipeline has mostly dried up since many houses have lost their equity buffer.  I don’t have direct experience with this but have heard that it is generally not easy getting a business loan, the type of loan that is riskiest unless it too is essentially secured in some other manner (property, receivables, etc…).

As a customer, if in the medium to longer term, if you assume that interest rates will stay very low, then you have options that you probably wouldn’t have considered otherwise.  For one – you may just want to consider taking a portion of your money out of the bank and just convert it into gold in your safety deposit box.  The biggest argument against gold historically is that it doesn’t produce a return – it just sits there, and has storage costs to boot.  While both items are true, a safe deposit box is cheap to rent each year (mine is about $100) but on top of it keeping your money in a financial institution has transaction costs, as well.  You can do the same thing by buying GLD the Gold ETF which may have other advantages with regards to transaction costs and sales taxes

Another alternative is to purchase foreign currency and put it in your safe deposit box.  This traditionally has been a terrible strategy because it earns nothing but in an era of almost zero returns on major currencies around the world the side effects of this strategy are lessening almost by the day.

Since the banks can only make so many loans that are basically secured and there hasn’t been a lot of impetus by them to move into more risky types of business loans, they are basically awash in cash.  In some circumstances, they have considered paying negative interest rates for large blocks of cash, and this has happened with short term debt instruments quoted in some markets, as well.

The last part of this is to strip the concept of “compound interest” out of your heads.  One of my blogs is for teaching kids about investing and if I was starting this years ago I would have made a big pitch for the advantages of investing your money for long periods of time and watching it grow with the “magic” of compounding interest.  It is hard to make this case with interest rates far below 1% unless you have large quantities or buy specific vehicles which take you near 1% and even that is a gigantic time frame to “double” your money.  If you assume 1% / year then it takes about 70 years (give or take) to double your money – better than the straight-line model of 100 years but in all cases virtually irrelevant for practical purposes (nice calculator here).

Thus some interesting side effects for me are

1) the lost “opportunity cost” of holding cash in gold is now negligible

2) the lost “opportunity cost” of physically holding non-US currencies is now negligible

3) the margin that financial institutions receive on interest is now very low and they will need to either expand into riskier non-secured loans (which they haven’t done) or start charging for services and transactions (or see their margins crumble)

4) with 3) above and interest rates near zero the real “value” of your money with the bank is in avoiding / minimizing transaction costs and being able to take advantage of better services 

5) the concept of “compounding interest” is basically dead on risk-less instruments, and for riskier instruments it is but one component of total return (probably the least essential component)

Cross posted at Chicago Boyz

 

 

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