It's no secret that many banks tend to do better when interest rates are rising. That's because the net interest margin (NIM), the difference between what banks pay for deposits and earn on loans, tends to rise when interest rates are rising, as long as banks can keep deposit costs from increasing too much. In March, the Federal Reserve quickly dropped its benchmark rate from 2% to zero, which is a big move because the Fed typically moves in quarter-point increments in calmer economic waters.

In a low-rate environment, banks can typically offset some of the pain from smaller spreads by lending more. Borrowers, often lured by lower monthly interest payments, jump at the opportunity to get a loan. That's why the Fed will lower rates when it wants to jump-start the economy, because it makes lending easier and debt easier to repay. But the coronavirus pandemic has made everything more complicated. Here's why this low-rate environment is different for banks right now.

The stony exterior of a bank.

Image source: Getty images.

Lending standards have tightened

In the second quarter, banks saw the effects of compressed net interest margins. Citigroup's (NYSE:C) NIM declined 31 basis points (0.31%), settling at 2.17% at the end of the second quarter, while Wells Fargo (NYSE:WFC) saw its NIM decline 33 basis points, settling at 2.25%. Most community banks in general also experienced margin compression, according to S&P Global.  

But despite the lower margins and lower-rate environment, banks are not lending more (excluding the Paycheck Protection Program). The Federal Reserve's July senior loan officer opinion survey found that banks are making it harder for businesses to obtain commercial and industrial (C&I) loans. They can do this by making more difficult terms on the loan, such as a larger downpayment up front, higher interest rates, more collateral, or a combination of the three. These standards have been applied to borrowers of all sizes, the survey found.

The survey also found that banks made it harder to obtain a loan in basically all major categories and saw weaker demand for loans aside from residential real estate. Lastly, banks reported in the survey that, in general, their lending standards are as tight as they've been since 2005, including the Great Recession.

This is going to make it difficult for banks to generate revenue, because while their margins are smaller and they aren't originating more loans, they still need to extend forbearance to people struggling from the pandemic.

What does this mean?

It means that banks, especially those that generate most of their income from loans, could struggle to generate revenue and might continue to see tough quarters ahead. Take a bank like Wells Fargo, which is the largest commercial lender in the country. Wells Fargo and lenders like it are going to struggle moreso than JPMorgan Chase (NYSE:JPM) or Citi, which will hope to offset lending struggles with trading revenue and investment banking. Wells Fargo does have some investment banking capabilities, but it's not a large part of the bank's business. Larger regional banks could also be in for a tough time, as those typically get most of their income from loans.