It is well known that banks tend to benefit from rising interest rates. As the Federal Reserve tries to fight inflation by raising its benchmark overnight lending rate, the federal funds rate, banks get a boost as many of the yields on current and new loans rise as well. If banks can control their deposit costs effectively, their margins widen. With banks currently in the most rapidly rising interest rate environment since the Great Recession and more rate hikes expected this year, most banks are licking their chops right now. Few banks benefit from rising interest rates as much as Bank of America (BAC -1.46%), which is about to see loan revenue explode. Here's why.
Net interest income set to take flight
A major source of revenue at most banks is net interest income (NII), which is the profit banks make on loans, securities, and cash after covering the cost to fund those assets. With the Fed jacking up the federal funds rate to a range of 1.5% to 1.75% in the second quarter, Bank of America really started to see the benefit to NII.
After steadily improving over the last three quarters, Bank of America grew NII by nearly 7% from the first quarter of this year, and management said there is a whole lot more coming. Bank of America Chief Financial Officer Alastair Borthwick said on Bank of America's second-quarter earnings call that management expects NII to grow by another $900 million to $1 billion in the current quarter, assuming modest loan and deposit growth and if deposit costs hold up as the bank expects. Borthwick also said the bank expects NII to grow even more in the fourth quarter. Most of this NII growth should fall to the bottom line, Borthwick added.
One analyst asked on the call if the bank could exit the fourth quarter with an NII run rate of $15 billion. Borthwick didn't say no, but rather that it's too early to tell. There are still a lot of unknowns, like where the federal funds rate will end the year and how loan growth might progress, especially if the U.S. economy enters a recession.
The other side of the NII equation is deposit costs because when rates rise, banks also eventually have to pay customers more for their deposits. Bank of America has greatly improved its deposit base by adding non-interest-bearing consumer deposit balances, which cost the bank next to nothing and they tend to stick around longer in a rising-rate environment. The bank now has more than $1 trillion of consumer deposits.
Deposit costs are going to go up, and this is a very intense rising-rate environment. But Bank of America has definitely improved its deposit base a lot in recent years, which should help the cause when it comes to NII.
What to expect
If Bank of America does exit the fourth quarter with an NII run rate of $15 billion, that sets the company on pace to earn $60 billion of NII in 2023. To put it in perspective, that would be up more than $17 billion from what the bank generated in 2021. There are still a lot of factors at play, including where rates end up, how loan growth trends, and where the economy goes. But make no mistake, NII should explode in the coming quarters, which bodes well for shareholders.