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A question for the finance gurus out there : Does the existence of the large spread mean that banks are pocketing the greater difference created by the Fed rate cuts rather than passing the rate cuts on to the consumer ?

For example suppose a bank could borrow for 5% and lend at 6% before the rate cuts. The bank makes about a 1% profit as compensation for taking the risk. Now the Fed cuts rates to 3% and the bank still lends at 6%. Did the bank's profit just triple to 3% ?

I've got a hunch that the answer is not so simple.

From the Money and Banking class I took as an undergrad, it is that simple.

My hunch? Banks need a larger spread today - they have all the subprime/alt-a losses they have to cover.

However, that doesn't explain the banks that didn't get involved with risky loans (and there are those out there). Maybe it's their turn to be greedy.

Well, it's almost that simple. The fed is trying to encourage more lending by lowering the costs to banks. Banks, like any other business, compete for market share. If all their costs go down, one savvy bank could lower its rates more than the next guy and get more market share.

However, they all distrust the environment now and demand more of a risk premium (aka the spread). They do this because they can no longer trust that you will make your payments, that your collateral (the house) will be worth more tomorrow than today, that you'll keep your job during the coming recession, or that inflation won't destroy the value of the loan they give you...

Thanks for the explanations Treeman and Dave. So it looks as if the Fed has lowered rates to mirror the change in the perceived risk premium. The banks get to recharge their reserves but the consumer does not get any immediate relief unless you consider that consumer rates might rise without the Fed cuts.

This also assumes that the free market guarantees that banks can't collude to keep consumer rates artificially high.