Most analysts (but not all) predicted a tapering of the Federal Reserves quantitative easing programs at their September meeting. While those predictions turned out to be premature, a growing consensus of Fed governors imply that tapering is happening sooner rather than later. This is what banks are doing to prepare.
Tapering will be here before you know it
Since the September Federal Open Market Committee (FOMC) meeting, several notable Federal Reserve governors have spoken out in favor of a taper.
Sandra Pianalto, president of the Federal Reserve Bank of Cleveland, released a speech this week stating that, "For me the improvement in labor markets seemed substantial enough to support a scaling back of the asset purchase program at last month's FOMC meeting."
She went on to forecast continued improvement in GDP growth between 2.5% and 3.5%. She estimates that full employment will most likely be reached in 2016, when the unemployment rate should fall below 6%.
Pianalto is not alone in her optimism at the Fed. Philadelphia Federal Reserve President Charles Plosser told attendees at a speech in Johnstown, Pennsylvania that the FOMC
...missed an excellent opportunity to begin this tapering process in September. In my mind, this illustrates just how difficult it is going to be to wean ourselves off the extraordinary process of increasing accommodation we have embarked upon and begin to normalize monetary policy in a timely manner that ensures a healthy and stable economy in the future.
He predicted 2.5% GDP growth for the remainder of this year, improving to 3% in 2014. He expects the unemployment rate to fall below 6.25% by the end of 2014.
Taken together and alongside the communications from the FOMC itself, the Fed is clearly telling the markets that the easy money policies will be ending, and the taper is just around the corner.
For banks, interest rates are core to business
Fellow Fool Morgan Housel has written that investors should not trade based on changes in Fed policy. That may be true for most businesses, but for banks, interest rate policy is core to day-to-day business.
Interest rates, driven by macro conditions, are the base for pricing the majority of bank products. Instead of using the traditional gross margin metric, bank accountants instead use net interest margin. If you're a bank investor, then you should care about Fed policy and interest rates.
Banks know this, and they are preparing their balance sheets for this rise. Bank of America (NYSE:BAC), for example, reported its interest rate sensitivities to investors as of June 30 of this year.
According to company calculations, if short-term and long-term interest rates rose in tandem by 100 basis points, net interest income would increase by $3.3 billion. If short-term rates rose 100 basis points and long-term rates remained stable, net interest income would increase $2.3 billion. If long-term rates rose 100 basis points and short-term rates were stable, net interest income would increase by just over $1 billion.
Bank of America, it's clear, is well prepared for rising rates. And these calculations assume that the company does not take any further actions to change the balance sheet when rates rise.
And its not just the large megabanks undertaking these preparations. Huntington Bancshares (NASDAQ:HBAN) also reported its interest rate sensitivity analysis to shareholders for June 30. Using a model that incorporates the bank's assets, liabilities, and hedges, they forecast that in both a 100 basis point increase and 200 basis point increase situation, the company's interest income would increase faster than interest expenses. Interest income would increase 37% and 37.9%, respectively, while interest expense would increase 33.6% and 35.5%, respectively.
This box must be checked on every bank investment
Interest rates today are particularly notable in the public conscious because of the unprecedented actions taken by the Federal Reserve. However, interest rates and Fed policy always matter to banks.
Before making any investment in a bank stock, the savvy investor will review and verify the interest rate sensitivity on the balance sheet. Interest rates and banks are simply too intertwined to ignore this key risk management measure.