Indeed, the banks’ ability to generate income in this low interest environment, created in part by the Fed’s actions, is still a major problem. Banks are coping with new regulations like the cap on fees banks can charge merchants — that rule led to a controversial announcement by Bank of America last week to implement new $5 monthly fees for debt cards. Meanwhile, the faltering U.S. economy could mean an uptick in credit-related losses for the banks, further squeezing their fragile bottom lines.

Operation Twist was intended to be a good thing, but the markets have been quite skeptical. The program designed to lower long-term interest rates through the purchase of billions of dollars in longer-dated Treasury bonds was intended to boost lending, while incentivizing people and businesses to spend rather than save. Trouble is, lower long term interest rates are great if you want to buy a home or if you want to expand your business, but with the real estate market still in a mess and the economy on shaky ground, it isn’t clear if there will be demand for more loans.

The initial reaction to the move — a severe slide in bank stocks — was probably not what the Fed had intended when it decided to go ahead with Operation Twist, but it shouldn’t have been a big surprise, either. After all, the Fed was directly attacking the banks’ main source of income – net interest income. A bank’s net interest income is the money it makes issuing loans, minus the interest it pays on its deposits and other investments. By moving to lower long-term rates, while at the same time keeping short-term rates at their historic lows, the Fed essentially squeezed the spread that the banks count on to make money.

Falling yields

The ideal world for a bank is one where the yield curve is sharply tilted up, as it means that they can borrow cheaply and lend out at a much higher rate. The Fed lowered short-term interest rates to almost zero in the aftermath of the financial crisis. The move was good for banks as it opened up that spread, allowing them to mint money. The government was happy because the banks started lending again.

But long-term rates started to come in this year as people started to buy longer dated bonds as a safe haven from the volatile markets. This sent yields falling, squeezing the banks’ bottom lines. The last six months shows the damage to the banks’ earnings. The net interest income generated by the four megabanks in the first six months of 2011, on a combined basis, was around $93 billion, according to company filings. That was around $12 billion (11%) less than what the banks brought in during the same time last year.

Citigroup (C) experienced the largest drop, down $4.2 billion (15%) in the first half of the year, while Wells Fargo (WFC) experienced the smallest drop at $1.2 billion (5%). Bank of America (BAC) and JP Morgan (JPM) also saw double-digit drops, down $2.7 billion (10%) and $3.4 billion (12%), respectively.

The banks’ third quarter results aren’t expected to be any better due to a combination of reduced net interest income and trading revenues from their investment banking units. Analysts have started to lower their estimates for the banks in the last few weeks just ahead of earnings announcements, sending stock prices falling. Part of the reason for the bad quarter has been the volatile swings in the market, which has crushed investor sentiment, hurting the broker-dealer units at the banks. Last week Jes Staley, the investment banking chief of JP Morgan, signaled that revenue in his division would be down by 30% from the quarter for the same time last year. Analysts slashed their estimates for Citigroup this week as they expect the bank’s expenses will grow faster than its revenues.

Sizing up the headwinds

While trading was tough in the third quarter, the banks’ overall profits will continue to suffer because of a drop in net interest income. The problem will probably just get worse in the coming fourth quarter with Operation Twist further squeezing the spread. So far, most of the banks have been able to stay in the black by using the cash they had set aside to cover future credit losses to plug the hole. This move, while justified in the short term due to declining delinquency rates, may come to haunt them if credit losses pick up due to the souring economy. The big commercial banks are expected to follow the same strategy to keep them from showing red in the third quarter. But eventually those loan loss reserves will dry up and the bank will need to start earning real revenue.

One way the banks could pump up their revenue and net interest income would be to lend more. While the spread is lower, the banks can make up the lost income in volume. Trouble is, the banks don’t want to take on that risk and would rather hold on to the cash. But for Operation Twist to work, the banks have to lend or their will be no real stimulus to the economy.

So there is the conundrum. The Fed is lowering long-term rates to induce people to go out and get a loan, but the banks won’t lend due to the risk and low reward. The slack demand for loans compounds the problem. Banks would have to go out and try to solicit people to take out a loan – mirroring the troubles that led up to the financial crisis, something no one wants to relive.

But by not lending, the banks are setting themselves up for further declines in their profitability. This comes at the same time that new consumer protection regulations come into effect, which will squeeze the banks’ noninterest income. Moves to raise revenue elsewhere have failed to materialize. Meanwhile, the implementation of the Basel III international banking accords could require the large systemically important banks in the U.S. to double or even triple their current Tier One capital ratio, forcing them to keep more cash on hand, which would leave the banks with even less money to lend out than ever before.

And then there are all those bad mortgages. Some banks have done a better job than others in addressing their mortgage troubles, but it is still a critical problem for all the banks. A third of U.S. homes are still underwater. Until homeowners feel that they are paying down an asset worth the effort, the threat of damaging defaults will hang over the banks. While increased capital requirements will hopefully buffer the banks from future losses, it probably won’t be enough to fend off cascading defaults.

One side has to budge in this stalemate. Either the Fed needs to quash Operation Twist or the banks have to accept more risk and start lending in large volumes. A failure to move could exacerbate the current weakness in the economy, setting the banks and the market up for another wild ride down the rabbit hole.