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What will happen to Citigroup's (NYSE:C) earnings when the Federal Reserve finally decides to raise interest rates?

  • Will they go up because of higher net interest income?
  • Will they go down because of lower fixed-income security prices?
  • Or will the impact reflect a combination of the two?

The answer, as you're probably not surprised to hear, is the third one.

Understanding asset sensitivity
It's tempting to say that higher interest rates will be good, essentially across the board, for the nation's biggest banks.

This is because most banks are "asset sensitive," meaning that the majority of their interest income comes from variable rate assets that are indexed to short-term interest rate benchmarks such as the Federal funds rate or the London Interbank Offered Rate.

For instance, Bank of America estimates that a 100-basis-point increase in both short- and long-term rates will raise the bank's annual net interest income by $4.5 billion. JPMorgan Chase offered a similar projection earlier this year, saying that it will earn $7.5 billion more before taxes if short-term rates normalize around 2.25%.

The problem with these estimates, however, is that they fail to mention one central point -- namely, that higher interest rates aren't categorically good.

Higher rates generally result in lower loan volumes, particularly residential mortgages. And even more critically, as Bank of America spells out in its 2014 10-K, "increases in interest rates may adversely impact the fair value of debt securities and, accordingly, for debt securities classified as [available for sale], may adversely affect accumulated other comprehensive income and, thus, capital levels."

The significance of available-for-sale securities
When a bank like Citigroup or Bank of America invests in a fixed-income security such as a government bond or a residential mortgage-backed security, it can classify that asset in one of two ways.

The first way is to classify it as "hold to maturity." This means that the bank doesn't intend to sell the asset before it matures. Because the bank will presumably get all of its capital back at that point, assets designated as such are reported at their amortized cost -- the original cost adjusted for premiums or discounts incurred at the time of purchase.

The second way is to classify the security as "available for sale." Because this means that a bank doesn't intend to hold the asset until maturity, at which point it'd recoup the principal, this classification requires financial firms to report the securities at their fair market value. For our purposes, this matters because interest rates and fixed-income security values are inversely related. As interest rates increase, the value of bonds and other fixed-income securities decreases, and vice versa.

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To grasp this relationship, it's helpful to think about the give and take between the price of a bond and the prevailing yield for substitute securities. Let's say that a bank pays $1 million for a 10-year government bond that yields 2%, or $20,000 per year. Six months later, the government issues a new round of 10-year bonds yielding 3%, or $30,000 a year. If the bank now wants to sell its bond, it will have to lower the price to $670,000; it's at this price that $20,000 in annual interest payments equates to a 3% yield.

It stands to reason, then, that the question of whether higher interest rates will fuel or depress profits at Citigroup (or any other bank for that matter) boils down to a comparison between the positive impact from higher net interest income versus the negative impact from depressed available-for-sale security values.

How does this balance out for the nation's third biggest bank by assets? According to Citigroup's latest 10-Q, a 100-basis-point increase in short- and long-term rates should translate into $1.9 billion in additional net interest income each year versus an immediate $3.9 billion drop in Citigroup's accumulated other comprehensive income, or AOCI.

Under this scenario, in turn, Citigroup expects that the negative impact to AOCI would "potentially be offset [by higher net interest income] over approximately 23 months."

Therein lies the lesson that Citigroup teaches us about interest rate risk. The answer to the question of how higher interest rates will impact a bank's earnings is: it depends. In the short-run, it's likely to be ugly. But given enough time, a well-run bank should be able to more than make up the difference.

John Maxfield has no position in any stocks mentioned. The Motley Fool recommends Bank of America. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.