You may or may not know this, but banks are having a heck of a time making money right now. Why? Because when they take your money (the money in your checking account), they're not making as much from it by lending it out because interest rates are so low.
As John Maxfield and Gaby Lapera discuss in this week's episode of Industry Focus: Financials, Bank of America (BAC +1.07%) offers a case in point. Listen below to learn why.
A full transcript follows the video.
This podcast was recorded on July 25, 2016.
Gaby Lapera: Let's talk a little bit about interest rates, a topic that is of perennial interest to us, and one that we perennially... I don't say we get wrong, because we always hedge our bets and say, "We don't really know what's going to happen." Interest rates were lower than expected this quarter. Again, partially Brexit is to blame, but there's just been a lot of stuff going on with interest rates in general that would affect the Fed's decisions whether or not to raise interest rates. One of those things is slow growth in China. There's that really bad jobs report in May, and also the volatility in the energy sector. Those are all contributing factors to why the Fed hasn't been raising interest rates like they hinted they would start doing back in December. They did raise it once.
John Maxfield: They did raise it once, which is better than zero times, so I will give them credit for that. Here's the thing about banks: If you were going to boil down what really has a significant impact on their earnings, nothing is more important than interest rates. Even these big universal banks with most commercial banking operations and investment banking operations, on Wall Street, even they generate about half of their income from interest income. What is that? That is going out, getting deposits, paying very, very little to borrow money from depositors, and then reinvesting that money in higher interest earning assets, be it loans or some type of fixed income security.
If interest rates are really low, that's going to decrease or hold down the amount of money that you're earning by reinvesting those deposits into higher interest earning assets, so that's why interest rates are so important. To a point you made, we are at this historically low point in interest rates. They fell during the financial crisis when the Federal Reserve was trying to free up the credit markets, and because the economy just hasn't picked up the amount of steam that the Federal Reserve wants to see at this point, it just hasn't felt comfortable raising interest rates, and that's just creating these economic headwinds for banks in terms of earnings.
Lapera: Yeah, and if you're a consumer, this is a great time to get a loan because your interest rates, if you have a fixed rate mortgage, are going to be super low, but if you're a bank, it's not a great time for you, basically. For most banks, this isn't the biggest deal in the world. It's just their profits are stagnant, but for some banks it's a lot bigger of a deal that interest rates aren't rising.
Maxfield: It's a big deal for everybody, but it's a really big deal for some of these banks, and let's talk about one in particular. When I think about the banking sector, the story right now is what's going to happen with Bank of America, and this is why. Bank of America, if you look at its profitability, so its return on equity, it hasn't generated a high enough return on equity in all eight years since the crisis, to exceed its cost of capital. What does that mean? That basically means that Bank of America is out there getting money and has its shareholder's capital, and let's say it's paying 8%. That's what shareholder require of it in terms of dividends or profitability or whatever it is, but then it's only earning let's say 6% on its equity, so it's actually destroying shareholder value. One of the reasons it's destroying shareholder value is because interest rates are so low, so it's not generating enough from its asset portfolio.
The other reason is that these regulations passed since the financial crisis have really come down hard on large universal banks so that they have to hold more capital. They have to hold more liquidity on their balance sheet. They have to do all of these different things that weigh on their profitability, and Bank of America is in a situation where unlike JPMorgan Chase, it's not number one on Wall Street, and unlike Wells Fargo, it's not number one on Main Street, so it's playing second or third fiddle in both of its core markets, and that has impacts on its margins, because it's not getting the volume of business that its competitors are getting. Because of that, its profitability has stayed low like this.
The CEO has even come out to say, "Look, we are not going to be able to earn our cost of capital unless interest rates rise a little bit." Until that happens, Bank of America is going to be in this precarious situation where shareholders are going to be saying, "Look, at some point, you guys have got to be earning your cost of capital," and if interest rates stay low for let's say two decades, like they have in Japan, Bank of America is going to have to make business decisions to tweak its business, i.e., get rid of its capital markets business, trading business, that has such a big impact on its capital and liquidity requirements, in order to appease shareholders.
