The Conundrum of a Rising Rate Environment for U.S. Banks

Banks have become quite adept at protecting margins in today's super low rate environment. But with nowhere for interest rates to go but up, are U.S. banks prepared for the inevitable shift higher?

The risks in interest rate spreads
Deposits and loans remain the core business of the modern bank. During times of changing interest rates, loan and deposit rates reset at different intervals -- and deposits generally reset faster. Therefore, as rates rise, the money banks pay to depositors -- their interest expenses -- will increase faster than the money they collect from loans -- their interest income. If this happens, expenses will rise faster than income, squeezing margins until rates stabilize.

Big banks have the advantage
Larger and more sophisticated banks, such as Bank of America (NYSE: BAC  ) , JPMorgan Chase (NYSE: JPM  ) , and Wells Fargo (NYSE: WFC  ) , have an advantage in this process.

Because of their size, these institutions can invest in more derivatives, swaps, or other contracts to mitigate the risks of a rising rate environment. While many smaller institutions do invest in hedges for interest rate risk, the complexity and cost of fully managing that risk can be prohibitive. With their scale, the large banks can devote human and capital resources to units solely focused on hedging risk.

Bank of America, for example, generated $10.9 billion in net interest income (income less interest expense) during the first quarter on a 2.43% net interest margin. JPMorgan yielded $10.9 billion as well with a similar 2.37% margin, while Wells generated $10.7 billion from an impressive 3.48% margin. As rates rise, expect the big banks to maintain this income-producing ability as they all have world-class hedging units tasked to offsetting interest rate risk.

Without the scale of the larger banks, it's more difficult for smaller institutions to allocate human and capital resources to build hedges that mitigate the risks of a changing rate environment.

Source: FDIC Quarterly Q4 2012.

Furthermore, these larger banks tend to offer additional products and services that produce non-interest income. These bolt-on businesses, from corporate treasury services, investment banking, and advisory services for businesses, to insurance, wealth management, and real estate services for consumers, can mitigate a decline in earnings on the loan side of the bank.

Of Bank of America's total revenue, 46% is attributed to net interest income. JPMorgan attributes even less with 43%, while Wells Fargo is more dependent on net interest income with 49% of total revenue coming from loans. For smaller institutions, these ratios tend to skew much higher. The chart below from the FDIC Quarterly Q4 2012 report paints the picture; large institutions generate more than double the non interest income as smaller institutions, even as a percentage of assets.

One certainty
Eventually, interest rates will go up. When they do, it will mean the U.S. economy is most likely in a self-reinforcing recovery; that the employment market is on the mend; and therefore, that consumers are on better financial footing.

It will also mean that the banks will be working to protect net interest margins, a challenging task for any institution. But the big banks -- the Bank of Americas, the JPMorgans, the Wells Fargos -- that are best suited to the task. If you want to invest in this sector, look to the big banks with the sophistication, scale, and diversified incomes to ride out the transition in interest rates better than their smaller competitors.

Many investors are scared about investing in big banking stocks after the crash, but the sector has one notable stand-out. In a sea of mismanaged and dangerous peers, it rises above as "The Only Big Bank Built to Last." You can uncover the top pick that Warren Buffett loves in The Motley Fool's new report. It's free, so click here to access it now.


Read/Post Comments (2) | Recommend This Article (1)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On May 24, 2013, at 7:25 PM, Rusty56 wrote:

    I am under the impression the banks are looking forward to rising rates, their margins will grow and profits will follow.

  • Report this Comment On May 24, 2013, at 7:42 PM, ronbeasley wrote:

    I second that comment. This article is inaccurate. Bank CEO's will tell you the opposite - their interest income will rise faster than their deposit costs. Readers should listen to bank CEO's, not bloggers trying to sell them newsletter subscriptions. Always go to the source, not someone's interpretation. Takes more work but you get accurate information.

Add your comment.

Sponsored Links

Leaked: Apple's Next Smart Device
(Warning, it may shock you)
The secret is out... experts are predicting 458 million of these types of devices will be sold per year. 1 hyper-growth company stands to rake in maximum profit - and it's NOT Apple. Show me Apple's new smart gizmo!

DocumentId: 2452472, ~/Articles/ArticleHandler.aspx, 10/25/2014 5:05:13 AM

Report This Comment

Use this area to report a comment that you believe is in violation of the community guidelines. Our team will review the entry and take any appropriate action.

Sending report...


Advertisement