After two years of an ultra-low interest rate environment, Bank of America (BAC 2.06%) had high hopes for its lending business coming into the year.
Not only did America's second-largest bank by assets believe business activity might finally pick up, but it also expected the Federal Reserve to raise interest rates to combat some of the highest levels of inflation seen in decades.
The Fed has not only raised rates, but it's raised them aggressively, much more so than anyone would have likely imagined when the year began. This could enable Bank of America's loan and securities business to perform even better than management initially thought. Let me explain.
Net interest income ramping up
A key part of any bank's business is a revenue source called net interest income (NII), which is the profit banks make on loans and securities after covering the cost to fund those assets.
Most banks tend to benefit in a rising-rate environment because the yields on more of their loans and securities will move higher as the Fed raises rates. The yields on a bank's deposits will move higher as well, but in a more muted way, especially if a bank has a good sticky, low-cost deposit base. Bank of America has one of the best in the business, at least when compared to other large banks. With the federal funds rate now inside a range of 3% and 3.25%, Bank of America has already started to see the benefit to NII.
Image source: Bank of America.
Additionally, we already know from Bank of America's second-quarter earnings call that NII is only expected to improve in the back half of the year, as the Fed has only gotten more aggressive with rate hikes at its June, July, and now September meetings.
Bank of America's CFO Alastair Borthwick told analysts on the Q2 earnings call that assuming modest loan and deposit growth and disciplined pricing on deposits, NII in the third quarter would grow by $900 million to $1 billion from the $12.5 billion of NII the bank generated in Q2. Then Borthwick said management expects NII to grow at an even faster pace in the fourth quarter. When an analyst asked if the bank could exit Q4 with a $15 billion NII run rate, Borthwick said it is too early to tell, but didn't rule it out either.
This guidance was provided after Q2 ended. Today, interest rates are now expected to end the year even higher than they were in July when the conference call took place. At its September meeting, the Fed raised the federal funds rate another 0.75%, and the Fed's median forecast is for its benchmark rate to end the year at 4.4%. That implies another 0.75% rate hike and a half-point hike at the Fed's two remaining meetings this year.
Bank of America didn't provide its rate assumptions in July. But on its July second-quarter earnings call, JPMorgan Chase said it expected the federal funds rate to end the year at 3.5%, which is likely where Bank of America had it pegged.
At a recent conference last week, Borthwick confirmed the bank's guidance from Q2 and said that, if anything, the outlook for NII has "moved slightly positively, and our deposit beta experience has been consistent with or maybe even slightly better than we thought."
What about the current environment?
It's true that the economic outlook is getting more challenging and that a more severe recession in the near future seems to be getting more inevitable. Like all banks, Bank of America has seen its investment banking business take a hit from the lack of initial public offerings and other issuances. Mortgage banking is also getting hammered due to rising rates, and a severe recession could depress loan growth and consumer spending.
But a big chunk of NII at Bank of America is coming from investing excess liquidity into bonds, which have seen their yields rise with the federal funds rate. And while loan losses are expected to rise at some point, they are still incredibly low right now.
While the business environment is becoming increasingly difficult, banks have not experienced a rising rate environment like this since before the Great Recession. As such, I expect Bank of America to finish the year strong when it comes to NII and potentially see that revenue line come in better than expected.
