Thomas-Hoenig

Thomas Hoenig, president of the Federal Reserve Bank of Kansas City, says that the near zero interest rates is a subsidy for the large banks and turns savers into debtors.

Right now, banks can borrow money from the Fed at 0.25% and buy Treasury bonds for 2+% and keep the extra money. This is much like the “Sarkozy trade” in that banks can borrow from central banks at a cheap rate and invest that money in government bonds, creating extra capital.

Hoenig says that the Fed should deploy tight monetary policy to avoid inflation or asset bubbles. The Fed president says that the near zero rates “redistributes wealth in this country from the saver to the debtor by pushing interest rates on deposits and other types of assets below what they would otherwise be”.

Banks ((Financial Select Sector SPDR (ETF) (NYSE:XLF)) , ((iShares Dow Jones US Financial (ETF) (NYSE:IYF)) are struggling right now under the low interest rate environment. There have been reports of Bank of America Corp (NYSE:BAC) CEO, Brian Moynihan trying to cut costs because new regulations and near zero interest rates are cutting into the company’s revenues.

It doesn’t get much better for the community banks. Community banks have one focus, loans. Unlike the behemoths JPMorgan Chase & Co. (NYSE:JPM) and Bank of America, community banks only need to rely on loans for income. When you have near zero interest rates over a long term period, it can hurt your bank and cause a bank failure. However, Fed Chairman Ben Bernanke recently told community banks not to worry that the low interest rates will help you in the long run.

The Fed believes this because in theory when loans are cheap people will take out more loans. However, this is absurd to make this assumption given the challenging economic environment. There is still high unemployment. Does Chairman Bernanke honestly believe that someone will no income is going to go get a loan or that the bank will give someone a loan with no income, for that matter?

That is absolutely ridiculous and the community bankers are not drinking the Kool-Aid either. Banking as a whole needs loans to survive, that is the basic money making venture that banks have. Nowadays, bigger banks can rely on investments and underwritings, etc for alternative sources of revenue but community banks do not have that option.

The bottom line here is that although near zero interest rates have their positives, the negatives are starting to outweigh. Banks are losing profits and inflation is creeping in the wakes, waiting to show itself. The last thing we need is another banking disaster and inflation. The only thing we can do is to hope that Bernanke sees how this low interest rate environment is doing more bad than good and ultimately raises the rates earlier but for some reason I do not see that happening.