How Interest Rates Impact Bank Earnings -- In Q4 and Beyond

A lot of conversation in the bank industry over the past few years has centered around the hope that interest raise will soon begin to rise, which was indeed the case in the fourth quarter of last year. However, what's important to understand is that higher rates aren't invariably good for banks.

To learn why this is, listen in to the segment below of this week's episode of Industry Focus: Financials, in which The Motley Fool's Michael Douglass and contributor John Maxfield discuss how higher rates are good for bank income statements but bad for their balance sheets.

A full transcript follows the video.

This podcast was recorded on Jan. 23, 2017.

Michael Douglass: Let's also talking short-term and long-term interest rates. People always talk about interest rates like they're one thing, but there are two different main streams to talk about.

John Maxfield: Yeah. If you think about banks, what are banks? The way I like to simplify in my own head, because I have a pretty simple mind [laughs], is that a bank is really nothing more than a retail type of operation, but instead of a bookstore that sells books, banks sell money. And interest rates are the price of money. I.e., when you get a loan, the bank is basically selling you that money to use for a time being. The price that you are paying for that is the interest rate on that. So, as interest rates go up, the price of money goes up. And as the price of money goes up, well, so do bank revenues. So, that is a really good thing. But here's the thing. The banks have been talking now for a few years, waiting for interest rates to come up, hoping for them to come up because profitability in the sector has been so hard. But, in the fourth quarter, when they did come up, the short-term rates didn't come up until December, when the Federal Reserve, the committee that sets monetary policy, when they decided to increase interest rates, that didn't happen until December, so, a little bit more than two-thirds of the way through the quarter.

Long-term interest rates, which are also are beneficial to banks, they shot up in the immediate wake of the election, just like bank stocks did. And they shot up, actually, by quite a bit, by 90 basis points. If you talk about that on a percentage basis, that means 0.9%. Now, that doesn't seem like a lot. But if you look at all these banks, in their regulatory filings, put out interest rate sensitivity analysis. And Bank of America (BAC 1.16%) said that, if short and long-term interest rates increase by 100 basis points, which is almost how much long-term rates shot up, it would earn $5.3 billion more over the following 12 months in net interest income. And net interest income is really high-margin revenue that essentially just falls to the bottom line. Then, we factor in that a bank like Bank of America makes like $5 billion a quarter, then basically, just by interest rates increasing by 1% would basically give Bank of America a full 'nother quarter of earnings on top of what it's already earning. So, it is a really big thing. But, because they came up so late in the quarter, the banks really aren't going to see that benefit until this year. That's why, I think, investors can and should feel bullish about bank stocks at this point.

Douglass: Yeah. Certainly, those year-over-year comparisons look like they're going to look pretty darn good for the rest of 2017. Of course, no one has a crystal ball and can predict the future. But that's what things look like right now. But, an interesting thing about interest rates -- and John, you and I were talking about this a bit before the show -- earnings obviously improve as interest rates go up, or they tend to, but book value will tend to go down. Why is that?

Maxfield: When you think about what a bank is, it's a highly leveraged investment fund. And in that fund, it holds two different types of assets. I'm speaking very generally. One type of asset are loans. The other type of assets are fixed income securities, things like a 10-year Treasury bill, mortgage-backed securities that are issued by Fannie Mae and Freddie Mac, things like that. Well, as interest rates come up, the value of the securities comes down, because those securities were issued under lower interest rates. So, as the new securities, which are basically fungible -- a 10-year Treasury issued in December for all intents and purposes isn't really different from a 10-year Treasury issued in October, except for the fact that if the interest rates go up, investors are going to earn a lot more from those, so they're going to be willing to pay more for those securities that are issued in a higher interest rate environment. What happens then is that all those securities that were existing and on their portfolio, their prices go down.

So, what we saw in the fourth quarter was -- and this is a statistic that Dick Bove, a well-known bank analyst, publicized in a recent report, is that if you look at 18 of the biggest banks in the United States, the ones that have thus far reported their earnings, their cumulative book values have fallen by between $17 [billion] to $18 billion. Now, here's the interesting thing about that. You think that there's some give and take here, higher interest rates are good for the income statement but they're bad for the balance sheet. But here's what's so interesting about this. Because of where we are right now, and because the way the regulatory environment has unfolded over the last few years, banks have to hold so much capital that it makes them look less profitable. Because, the way that banks estimate profitability is through the return on equity calculation, where you have income divided by capital. If you have more capital, then your return on equity is going to go down. So, what has happened now is, as these banks have had to revalue their portfolios down, that is actually going to make them look even more profitable, because their return on equity is going to go up. So, there's all these different moving pieces when you're talking about interest rates. Some are good, some are bad. But it looks to me like -- and I think this is probably the consensus out there -- is that as a general rule, higher interest rates are almost indisputably good for banks.