It should come as no surprise that banking is a cyclical business. After the bubble bursts, there is always lots of hand wringing and vows to be more rigorous in underwriting. Then the bubble refills and people start to worry more about losing market share to companies with less disciplined underwriting approaches. This leads to a free-for-all as everybody scrambles for market share by lowering their credit standards. The bad loans don't get paid back and the cycle starts anew.

In the past, the Fed has been able to recapitalize banks during the down times by cutting interest rates. Since banks were tightening their credit terms, the interest rates on loans remained high or got even higher. But with the lower interest rates, the amount that banks paid depositors immediately dropped. As a result, the spread between loan and deposit rates widened and the resulting net interest revenue helped to replenish banks' capital.

That is sort of happening now. Since the Fed cut rates from 5.25% to 2%, banks' net interest margins have widened. A look at Citigroup Inc.'s (NYSE: C) most recent quarterly statement reveals that between Q2 2007 and Q2 2008 its net interest margin climbed from 2.41% to 3.18%. During that same time, the average amount Citi charged for loans declined slightly from 6.41% to 6.21% but the rates it paid depositors fell much more -- from 4.42% to 3.30%. Unfortunately, I said it's sort of happening now because the wider spread is not generating enough additional capital to offset Citi's writedowns.