Banks Facing a Rate-Cut Squeeze

The Federal Reserve did the nation's banks no favor last week with its surprise half-point interest rate cut.

The cut, which dropped overnight lending rates to 1.25%, has sparked a losing streak for bank stocks, with the Philadelphia KBW Bank Index down nearly 5% since Wednesday. Shares of J.P. Morgan ChaseJPM and Wells FargoWFC led the retreat.

Some of the selling was inevitable, especially since the bank index had risen nearly 21% since the first week in October. But the surprise move is not only reviving fears that the economy is weaker than previously thought, it's also causing investors to worry about an earnings squeeze.

Net Bad

"At this point, rate cuts are more negative than positive for banks," said Harold Schroeder, a portfolio manager with Carlson Capital, a hedge fund that holds both short and long position in financial stocks.

Normally, when the Fed cuts interest rates, it's a boon for banks, because it reduces their own borrowing costs and enables them to pay out less money in interest payments to depositors.

This time around, however, many banks find themselves caught in an unusual Catch-22. That's because they risk alienating their customers if they respond to the Fed's latest cut by reducing the already low interest rates they pay on checking, savings and money-market accounts.

"We've kind of reached the floor on the deposit side," said Michael Stead, a portfolio manager with Wells Capital Management's SIFE financial services fund. "If the banks go any lower, they run the risk of losing market share."

Meanwhile, in order to remain competitive, banks have no choice but to reduce the interest rates they charge to customers who borrow money. And that's something that could put a pinch into the interest income banks generate, even if the Fed cuts help spur more consumer borrowing and mortgage refinancings.