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It's no secret that low interest rates are weighing on Bank of America's (BAC 1.70%) bottom line. What you may be surprised to hear, however, is just how significant of an impact higher rates will have on the nation's second biggest bank by assets.
Consider this: If Bank of America faced the same interest rate environment last year as it did in 2002, it would have generated an additional $20.5 billion in after-tax earnings, holding all else equal. That would have more than doubled its 2015 net income, taking the figure from $14.4 billion all the way up to $34.9 billion.
The impact on Bank of America's profitability metrics would be just as dramatic. Its return on assets last year was a mere 0.74%, which is meaningfully lower than the 1% return on assets benchmark that a typical bank strives for in normal times. Under the 2002 interest rate scenario, by contrast, the North Carolina-based bank would have earned a hypothetical 1.62% on its assets.
The point here is that higher interest rates will be a game changer for Bank of America and its shareholders. Because of its low profitability, the bank's stock trades for a nearly 40% discount to book value. But if Bank of America's return on assets exceeded 1%, it's reasonable to assume that its stock would trade on par with its book value if not at a premium thereto. Higher interest rates alone, in other words, could essentially lead to a doubling of the $2.2 trillion bank's stock price.
Data source: Bank of America. Chart by author.
To be fair, the year 2002 was a high point insofar as interest rates are concerned. Bank of America's net interest margin that year was 3.75%, meaning that it generated net interest income equal to 3.75% of its earning assets. Flash forward to last year and its net interest margin had dropped to only 2.20%.
But even though 2002 was a high point for interest rates, the story was the same in most years before to the financial crisis. For Bank of America to earn a 1% return on assets, its net interest margin needs to be roughly 2.75%. That was the rule rather than the exception prior to the crisis, as Bank of America's net interest margin exceeded this threshold in nine out of the 10 years from 1999 to 2008.
Although Bank of America is responsible for a large portion of its struggles over the past decade, the role of low interest rates shouldn't be ignored. To a significant extent, in fact, a bet on Bank of America is largely a bet on the seemingly inevitable likelihood that interest rates will eventually head higher.
