Many investors' portfolios have taken a beating in the current inflationary environment. And many people new to investing are wondering what to do to protect their hard-earned money. One industry that has historically performed well when the Federal Reserve raises interest rates is banks -- but some perform better than others. Here's why SVB Financial Group (SIVB +0.00%) is one of the best banks for your dollars in today's environment.
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Why SVB Financial benefits the most from rising interest rates
Banks typically borrow money from depositors and loan the money out to borrowers -- making profits on the difference between collecting higher interest from borrowers than they pay out to depositors.
Every bank can increase profits when the Federal Reserve raises the Fed Funds rate by raising interest rates for borrowers faster and higher than the interest the bank pays out to depositors. However, SVB Financial has two advantages over other banks that make it more effective in increasing its profits as interest rates rise.
First, 66% of SVB deposits sit in traditional checking or demand deposit accounts that pay no interest. In comparison, Factset reported in 2019 that median large bank holding companies only held 22.7% of total deposits in accounts that pay no interest -- meaning SVB pays depositors far less than other banks, which lowers the cost of making loans.
Second, SVB Financial predominantly originates business loans rather than home mortgages or consumer loans. Generally, rising interest rates make mortgages more expensive -- making mortgage loan demand decline. In contrast, when interest rates rise in response to the economy doing well, it can have a neutral to slightly positive effect on business loan demand, especially in the earlier rounds of rate increases. Therefore, banks that focus on business loans rather than mortgage loans often have stronger loan demand in a rising interest rate environment.
As a result of SVB's business loan focus, its first-quarter 2022 average loans grew 45% year over year to $67 billion. In comparison, SVB's first quarter 2021 average loans increased only 37% year-over-year, so loan activity appears to have picked up over last year. More loan activity means more interest income, and when combined with lower interest paid to depositors, SVB profits can rise significantly as interest rates rise.
Accordingly, SVB's Q1 2022 net interest income (NII), or profits from interest, rose 15% over the previous quarter and up 64% year over year. In comparison, Q1 2021 NII only grew 26% year over year.
In addition, SVB management recently raised its 2022 NII growth guidance, from the high end of the 30%-40% range to slightly above 50%, which shows SVB's increased confidence in tailwinds from rising interest rates. What's more, this guidance doesn't include the impact of eight potential additional rate hikes the Fed may carry out. If more interest rate hikes take effect, SVB Management expects each extra 25 basis points to create $100 million to $130 million worth of annualized net interest income.
The bottom line
The worst-case scenario for SVB is that rising interest rates eventually push the economy into a recession, as experts have recently warned. Currently, rising interest rates have negatively affected loan growth for only some SVB clients: venture capital and private equity companies. And even though SVB has strong loan growth tailwinds today from its high-tech and life-science clients, a severe economic slowdown could crimp loan growth from all its clients, hurting SVB's NII. As a result, while SVB management expressed confidence about its loan guidance on its first-quarter earnings call, investors should monitor the effects of rising interest rates on SVB's loan growth moving forward.
SVB currently has a price to book ratio of 2.08, which is very high for a bank. However, SVB Financial Group's return on equity (ROE), a measure of profitability, is 14% compared to an average ROE of 12.28% for companies of a similar asset size -- justifying SVB's current valuation for those thinking that SVB's profitability will soon rise significantly.
The upshot for investors is that today's market can be perilous for all companies. But if you expect interest rates to rise further, very few companies make for as solid an investment as SVB Financial.
