- The Federal Reserve declined to raise interest rates at the latest meeting of its Federal Open Market Committee, the body in charge of U.S. monetary policy.
- Bank of America's CEO told analysts at an industry conference that trading revenues are likely to drop in the third quarter, which ends on the last day of this month.
The Federal Funds rate, the rate at which banks lend excess reserves to each other on an overnight basis, has hovered just over the 0% mark since the financial crisis. Although it's tempting to think that low short-term interest rates are good for banks, as they make money by borrowing funds at low short-term rates and then lending the proceeds out at higher long-term rates, developments during the past four decades have altered this model.
In the late 1970s, interest rates soared as the Fed sought to slay double-digit inflation triggered by the 1973 OPEC oil embargo. This ignited massive losses at banks and savings and loans, which were invested in fixed-rate mortgages that yielded less than 10%, while their funding costs soared to upwards of 18%.
The bank industry's response was to mitigate interest-rate risk going forward. One way they did so was to complement their interest income with fee-based revenue. It's now axiomatic that banks should generate roughly half of their revenue from the latter.
The second way they combated the pernicious impact of high short-term interest rates going forward was to emphasize either variable-rate loans or shorter-term loans to businesses. As opposed to the standard 30-year amortization period of a residential mortgage, commercial loans are regularly tied to the prime rate and mature in 10 years or less.
Most big banks -- including Bank of America, JPMorgan Chase (NYSE:JPM), and Citigroup (NYSE:C), among others -- are now designed to make more money when short-term interest rates rise. In Bank of America's case, in particular, it has said in the past that a 100-basis-point increase in short-term rates, with long-term rates holding steady, would boost its net interest income by $2.2 billion a year.
This is why interest rates are currently the single most important external force causing bank stocks to fluctuate in value, as I discussed here. It's also for this reason that bank stocks tumbled across the board on Thursday following the Fed's announcement that it isn't prepared to begin raising rates thanks to tepid net exports, and virtually no inflation to speak of.
On top of this, Bank of America's CEO Brian Moynihan acknowledged at the Barclays Financial Services Conference on Thursday that revenue from its trading operations is likely to fall by 5% to 6% in the current quarter. His comments echoed those of Citigroup CFO John Gerspach, who forecasts a 5% decline in his bank's trading revenue. Both alluded to the fact that the drops would come in their fixed-income, currencies, and commodities, or FICC, units, while revenue from equity trading would likely see a small boost.
Trading isn't as important to Bank of America as it is to JPMorgan Chase or Citigroup, both of which have larger Wall Street operations. In the first six months of 2015, Bank of America generated $3.9 billion in trading account profits compared to $6.5 billion and $4.7 billion at JPMorgan Chase and Citigroup, respectively. But 5% of a big number is still a big number. In Bank of America's case, it translates into roughly $100 million in quarterly pre-tax income.
Taken together, it's little surprise that shares in Bank of America, as well as JPMorgan Chase, Citigroup, and others, were all down substantially following the news.
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.