If you own bank stocks today, you'll be thanking yourself for years to come. The reason is that depositary institutions like Wells Fargo (NYSE:WFC), Bank of America (NYSE:BAC), and M&T Bank (NYSE:MTB) are primed to earn considerably more money once short-term interest rates increase.
Given the traditional business model of a bank, it's tempting to conclude that the ideal interest rate environment is one in which long-term rates are high and short-term rates are low. This is because banks, as a general rule, generate a considerable portion of revenue from arbitraging interest rates -- that is, borrowing money at low short-term rates and then lending it back out at higher long-term rates.
The problem with this view is that it's somewhat out of date. Take a look at most bank balance sheets today, and you'll find loan books dominated by commercial loans. And commercial loans, in turn, are typically indexed against short-term rates. Added to this, most banks hold a significant amount of noninterest-bearing deposits, which don't become more expensive with a rise in short-term rates.
When you take these things into consideration -- the predominance of commercial loans on bank balance sheets and the inelasticity of noninterest-bearing deposits -- then it becomes clear that the ideal interest rate environment for most banks is one in which both short- and long-term rates are high.
This is something that KeyCorp's chief financial officer Donald Kimble, who recently joined the bank from Huntington Bancshares, discussed in the middle of last October. "While Key, along with other asset-sensitive banks, generally benefit from a rise in both short-term and long-term rates, the duration and characteristics of Key's loan and investment portfolio position us to realize more benefit from a rise in the shorter end of the yield curve."
So, how can you tell whether a specific bank is positioned to benefit more from a future (and inevitable) rise in short- and long-term rates going forward? One way is to compare the proportion of noninterest-bearing deposits they have relatively to total liabilities -- see the table above. The bigger the proportion, the smaller the uptick in funding costs relative to an increase in the earning-asset yield.
By this measure, of the 10 biggest traditional banks in the country, the three that are best primed to benefit from the eventual rise in rates are M&T Bank, Fifth Third Financial, and PNC Financial. Of the big four banks, meanwhile, Wells Fargo and Bank of America comfortably outpace Citigroup and JPMorgan Chase.
Does this mean that these banks will necessarily outperform their counterparts? Not necessarily, as there are a multitude of moving parts that weigh on profitability at multibillion-dollar banks like these. At the same time, however, it's something that investors would be wise to consider when buying bank stocks.
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John Maxfield owns shares of Bank of America. The Motley Fool recommends Bank of America and Wells Fargo. The Motley Fool owns shares of Bank of America and Wells Fargo. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.