Two major decisions by the Fed yesterday are going to have an immediate impact on the banking system and the cost of capital to banks.
The first decision was to raise the Fed funds target rate to a range of between 0.25% and 0.50% from 0% and 0.25%, as indicated in the FOMC statement.
This moved the Fed funds effective rate (FFER) from about 0.125% to 0.375%.
The second, which was decided as the preferable route toward accomplishing the first, was to increase the interest rate paid on excess reserves by the Fed to its member banks to 0.50% from 0.25%, as was detailed in the accompanying note, "Decisions Regarding Monetary Policy Implementation."
These adjustments had the instantaneous impact of roughly doubling the costs of capital to all but the four largest money centers, with assets in excess of $1 trillion each, and the 19 largest national banks, with assets of between $100 billion and $1 trillion.
The super-regional, regional and community banks that comprise the majority of the roughly 6,500 banks in the U.S. all immediately experienced this enormous increase in the rate of interest they will have to pay to access Fed funds, with the size of that increase being inversely proportional to the size of the bank as measured by assets. The smaller the bank, the bigger the increase in the cost of capital.
I last addressed the mechanics of the FFER and the range of costs of capital to the banking system in the March column "Effective Rate Puts Fed in a Fix." I urge you to read it again as a primer for what happens next within the banking system, as I will not review the process in this column.
The instantaneous response to the Fed's announcement of the increase in the fed funds target rate was that the costs of fed funds to the smallest banks moved from about 0.31% to 0.55%, as is exhibited by the data on such tracked by the Federal Reserve Bank of New York.
Also, note from the New York Fed data that the cost to the largest banks, the money centers and nationals, did not increase, shown as 0.08% for the low end of the fed funds range.
Essentially and actually, the Fed's decision greatly enhances the profitability of the largest banks while simultaneously putting enormous pressure on the profitability of the rest of the banks.
This in turn provides an immediate catalyst for an increase in mergers and acquisitions (M&A) by all the smaller banks. The logical and prudent course for each of them to take is to pursue offsetting efficiencies that may be achieved through consolidation of operations on the assumption that the Fed is at the beginning of a rate hiking cycle.
This activity has been under way for decades, but this rate hike and the risk that the Fed will follow through with more provides an urgency that has not been experienced.
The fact that I believe the Fed will reverse course on tightening and expand its balance sheet again sometime in 2016 is a separate issue that I will address in later columns.
From the perspective of bank owners and officers, that issue is largely irrelevant as the prudent course of action is to assume that the cost of capital increases will continue and, more importantly, that their competition will accelerate their pursuit of consolidations to counteract that impact and beat out their existing competitors for the limited capital available for M&A.
The best analyst to follow about this issue specifically, and the opportunities that will arise out of it for investors, is Real Money columnist Tim Melvin, who has been active in the bank M&A space for two decades and last addressed the issue in the Dec. 7 column, "Don't Miss the Opportunity to Buy Community Bank Stocks."
This is an issue that requires the great expertise Tim will provide and is not something I would attempt to game without him, as the outcomes for the community banks and some of the regionals will be binary.
That is that the banks that successfully navigate the M&A process will reward investors handsomely, but the ones that don't risk an increasingly probable course of being driven out of business.
If you want to speculate on this as a trend rather than the individual securities Tim advises on, there are a few ETFs to consider: First Trust NASDAQ ABA Community Bank ETF (QABA), SPDR S&P Regional Banking ETF (KRE) and iShares U.S. Regional Banks (IAT).
Again, though, my advice is to go with Tim.