Banking's Future Woes

Isn't it great getting that fat return on your money market account? Major players such as E*Trade (Nasdaq: ETFC), Countrywide (NYSE: CFC), and AIG (NYSE: AIG) are offering yields of around 5% just for hanging on to your cash. That's some of the easiest money out there.

As good as it is for us, though, it may be putting banks in a tough position. An article in yesterday's Wall Street Journal (subscription required) discussed the rapidly falling margins that banks are collecting on their cash.

The math is pretty straightforward -- all of our favorite banks, from The Bank of Nova Scotia (NYSE: BNS) to Wells Fargo (NYSE: WFC), borrow cash from various sources and lend it back out. The banks pocket the difference between what they pay lenders in interest and what rolls in from the loans they make -- otherwise known as the interest margin.

But now -- just as many investors are rallying around the Federal Reserve's rate cuts as a support for the lousy credit market -- those same rate cuts are bringing down the rates that banks can charge for their loans. Meanwhile, they've had to keep the rates that they pay out relatively steady in what has become fierce competition for funds. So let's think about what this means: While everyone is busy worrying about writedowns at the financial institutions, the shrinking interest margins could be quietly eating away at them as well.

So the big news has been that the banks are busily scrambling to keep their balance sheets as solid as possible, but when earnings reports for the fourth quarter start rolling out, we could see that things are -- yes, believe it or not -- even worse than expected.

More financial Foolishness:

• Invest Like a Pro
• The Cost of Cash for Merrill
• Make Money the Old-Fashioned Way