For the banking industry and its investors, 2016 was the first year in a long time that could be referred to as a "great" year. The financial crisis is well in the past, and the election of Donald Trump as president of the United States has given the industry a renewed sense of optimism. Bank of America (BAC +1.38%) was one of the best performers in the sector, but there's reason to believe that the good times could still be in the early stages.
Image source: The Motley Fool.
Bank of America would benefit from higher interest rates more than most
The economy is improving, and the Federal Reserve finally completed a much-anticipated interest rate hike in December 2016. More importantly, the Fed has projected that interest rates will rise several more times over the coming years, including three rate hikes in 2017.
Bank of America says that a 100-basis-point increase in interest rates would translate to $3.4 billion in additional net interest income for the bank over a 12-month period. CEO Brian Moynihan's comments from Bank of America's fourth-quarter earnings report are consistent with this, as he said the bank expects a $600 million increase in net profit per quarter when compared with 2016.
All banks should benefit from higher interest rates, but Bank of America will benefit more than most. As my colleague, John Maxfield recently discussed, one big reason is that the bank has significantly more noninterest-bearing deposits than the rest of the "big four" U.S. banks. These deposits, such as standard checking accounts, enable the bank to capitalize on higher interest rates because as rates rise, the bank can lend this money out at higher rates, but its cost of capital stays put.
Additionally, Trump's plans to create job and wage growth could produce a surge in business for the banks. Higher incomes and lower taxes would mean more money in Americans' pockets to deposit into checking, savings, and brokerage accounts. And since more Americans would be able to qualify for mortgages and auto loans, lending demand could rise as well.
What lower regulations would mean
Trump has also promised to lower regulations, which he sees as an obstacle to the U.S. economy reaching its full potential.
For banks, this could mean repealing or modifying the Dodd-Frank rules, which were passed in the wake of the financial crisis. These regulations have generally made the cost of doing business more expensive for banks, especially when it comes to lending. Small-business loans have become especially difficult to come by in recent years, leading to a wave of alternative lenders. Dismantling Dodd-Frank, as Trump has pledged to do, would save the banks money on compliance expenses and produce a surge in lending volume.
A more efficient bank
There are several other reasons for investors to be optimistic about Bank of America's potential as we head into 2017, many of which have to do with continued efficiency and asset quality improvements.
For example, the bank's noninterest expenses in 2016 were nearly $3 billion less than a year ago. In fact, since Moynihan took over as CEO in 2010, Bank of America's noninterest expense has fallen by about $18 billion. As part of this, the bank continues to shrink its physical footprint, and has 2% fewer employees than a year ago. Impressively, the bank's noninterest expense shrunk in every measured area, including equipment costs, marketing expenses, and telecommunications costs, to name a few.
Furthermore, the bank's net charge-offs continue to fall, dropping by 12% year over year.
Image source: Bank of America.
While the bank's 66% efficiency ratio leaves something to be desired, it's significantly better than last year's 70% figure.
Bank of America's best year yet?
If interest rates rise as expected, Trump's wage and job growth plans start to materialize, and regulations get slashed, it's entirely possible that Bank of America's rally could be just getting started. In my mind, the key for making 2017 Bank of America's best year yet would be all of the above, plus a return to an acceptable level of profitability, which is generally defined as a return on assets (ROA) above 1% and a return on equity (ROE) of above 10%.
The bank has made strong progress in this area, mainly thanks to the efficiency improvements I mentioned. The ROA improved from 0.73% in 2015 to 0.82% in 2016, and the ROE rose from 9.1% to 9.5%. If Bank of America can break through the 1% and 10% barriers and Trump starts to come through on his promises, this could be a very good year for Bank of America.
