On Wednesday, the Federal Reserve announced it is increasing its benchmark interest rate by 0.75% in its continued effort to fight inflation.
Rising interest rates impact every part of the economy, from how much interest you earn on your deposits to the amount of interest paid on credit cards and other loans.
Banking stocks are sensitive to changes in interest rates and can do quite well when interest rates rise. However, rising rates have another effect that can hurt banks. Here's how this trend could affect one of Warren Buffett's biggest holdings.
Berkshire Hathaway CEO Warren Buffett. Image source: The Motley Fool.
What higher rates mean for banks
Bank stocks make money from the difference between the interest earned on loans and the interest paid on deposits. When interest rates are low, banks make less money on loan interest, which is offset slightly by lower interest rates paid on deposits.
Net interest margin (NIM) measures the difference between interest earned and paid out, divided by the bank's average earning assets. Banks have seen NIM fall as interest rates were held near record-low levels for over a decade since the Great Recession in 2008-2009, resulting in less net interest income.
Image source: FDIC.
Why U.S. Bancorp expects earnings to grow
U.S. Bancorp (USB 1.18%) provides banking services through 2,200 branches across the Midwest and West of the U.S. The bank is one of Berkshire Hathaway's top holdings, and the conglomerate has owned the stock since 2007.
U.S. Bancorp saw its net interest income (NII) increase by 3.6% in the first quarter compared with last year, as investments and loans increased from the previous year. In its March 31 filing, the bank said an immediate 50 basis point increase in interest rates would increase its NII by 2.15%, and that a gradual 200 basis point increase would increase its NII by 3.31%.
Higher interest rates will help the bank make more money this year, with CFO Terry Dolan telling investors he expects the bank's NII to grow 8% to 11% this year, which will help net revenue grow 5% to 6%.
The downside of higher rates
While banks benefit from rising interest rates, they are not immune from economic conditions. In the first quarter, the U.S. gross domestic product (GDP) declined 1.4% from the quarter prior. The Federal Reserve is now in a position where it has to raise interest rates to combat inflation, and this year it has increased the federal funds rate from near-zero levels to a target range of 1.5% to 1.75%. It expects to end the year around 3.4%.
High inflation means consumers will need to cut back on certain expenses, while high interest rates could deter borrowers from taking out loans. If conditions worsen and the economy enters a recession, customers could have difficulty paying back their loans, leading banks to see higher loan losses and delinquencies -- hurting the bottom line.
How U.S. Bancorp can survive as rates rise
While there could be short-term pain in the economy, U.S. Bancorp is ready to take advantage of higher interest rates, which will benefit it in the long run. The bank is selective with its loans, focusing on prime and super-prime customers with a lower risk of delinquencies. While the bank will feel pain if there is a recession, it should fare well with high-quality loans on its books.
USB PE Ratio data by YCharts
Fears of a slowing economy are weighing on all bank stocks, and U.S. Bancorp has lost 17% since the start of this year. The bank currently trades at a price-to-earnings ratio of 10, below its 20-year average of 14.1, and could be a solid buy for patient investors.
