Interest rates play a vital role in how a bank makes money—both directly (i.e. driving loan, securities and deposit pricing and borrowing costs) and indirectly (i.e. impacting loan demand, default rates, and capital markets activity). Over the past 30 years, interest rates have been in a secular decline since peaking in 1981 (with the 10-year Treasury yield currently at around 2.15 percent vs. nearly 14 percent in 1981). For much of this period (until more recently), banks have maintained liability-sensitive balance sheets, taking advantage of faster declining funding costs (liabilities) vs. slower-declining investment yields in loans/securities (assets). However, with 10-year Treasury rates rising about 50bps off its recent lows and most banks now asset-sensitive, banks should benefit if interest rates continue to move higher.
In the latest report from Deutsche Bank AG (NYSE:DB) (ETR:DBK), they take a closer look at the impact of higher interest rates on bank earnings, balance sheets and bank stock performance.
Interest Rates – Impact on Bank Earnings
Interest rates impact bank earnings through net interest margins/net interest income
The focus on net interest margin (NIM)/net interest income (net II) is a key factor driving bank earnings (and stock performance)—given net II is generally 60-65 percent of bank revenues. The conventional wisdom is that when rates rise, banks’ NIM/net II tend to decline, as banks have historically been more liability sensitive. However, NIM/net II could improve during a period of rising rates if banks are prepared for it (as they are currently), given the addition of new loans and assets that price off long-term rates (mostly residential real estate related assets and commercial real estate) would be at higher rates. Higher loan yields would also boost NIMs and net II over time.
In the current environment, rising long-term interest rates is generally a positive for banks. Higher long rates allow banks to deploy these assets into higher yielding areas—boosting NIMs. As a rule of thumb, we estimate the first 100bp boost in long rates adds 15-20bps to net interest margins (usually over 3 years). See Figure for historical bank NIMs and risk-adjusted NIMs.
Interest rates are a key driver of loan yields
Loan yields are generally derived from a market interest rate, depending on the type of loan as well as its maturity and risk profile. Fixed rate loans have yields that do not change over a set time period and are typically based on rates on the Treasury yield curve that correspond to the average maturity of the loans. Variable rate loans are driven off the London Interbank Offered Rate (LIBOR) or the prime rate, and re-price annually or more frequently.
Loans that price off short-term rates include most commercial, home equity, and credit card. Long-term interest rates also impact loan pricing (such as residential mortgages). Over time, there’s been a strong relationship between loan yields and the Fed funds rate (94 percent correlation), and to a lesser extent with 10-year Treasury rates (87 percent correlation).
Despite increasing competition for commercial loans, spreads (at 280bps above Fed Funds) remain well above their 25 year average (of 210bps) and recent low in 1Q07 (180bps) as short-term rates have declined meaningfully. C&I spreads tend to widen when short-term rates decline and vice versa. However, if competition continues to increase in commercial, we could see smaller C&I spreads. Separately, narrower mortgage spreads are about in-line with historical levels—although with tighter underwriting standards. Lastly, spreads for credit card and auto loans have been under pressure, but remain above historical levels.
Deposit pricing and the value of deposits
Currently, banks are under earning on deposits given the low/flat rate environment. As interest rates change, banks need to reprice deposits to reflect market rates. If priced incorrectly, a bank’s deposit base could shrink, which reduces its ability make loans and other investments. How soon and how much a bank reprices its deposits varies depending on each bank’s strategy, deposit base, and asset-liability position. If/when rates start to increase, deposit repricing may be higher as customers may seek higher yielding products as rates rise and commercial deposit customers draw down on deposits to invest and grow.
Interest Rates – Impact on Bank Balance Sheet
Higher rates at a measured pace are generally a positive for banks, given the uplift to asset yields, deposit margins, along with generally improving macro conditions. However, unexpected movements in rates and the yield curve can be a negative for bank balance sheets, more specifically, result in unrealized losses in accumulated other comprehensive income (AOCI) for GAAP capital. While banks currently have enough capital to withstand a meaningful unexpected rise in rates, in our view, the impact could be meaningful given banks have grown securities balances at a faster pace than loans over the past three years.
Why banks haven’t been positioned for rising interest rates until more recently
The relatively steep yield curve makes it tempting for banks to play the carry trade ( Figure below—which shows a proxy for the carry trade banks employ—investing in longer dated mortgage loans/assets, funded short). And with low rates and weak loan demand, many banks have added securities (and mortgage loans) while at the same time experiencing declines in shorter duration commercial/CRE loans (many of which are variable rate). From 2009 to early 2011, there was a steady decline in commercial/CRE loans (down 20 percent+) while securities/mortgages rose (up 15 percent over this period).
Deposit mix has shifted to lower cost deposits in recent years
Deposit pricing remains an important tool that banks use to manage net interest margins because deposits are usually a bank’s biggest cost of funding (in dollar terms). Given the steep decline in rates since 2008, banks have been repricing or running off higher-priced CDs, which has led to the steady y/y decline in CD balances (down 55 percent on average since mid-2009). Core deposits (including demand deposits, savings deposits, and other checkable deposits) have raised 55 percent y/y on average over the same time period.
Interest rates – Impact on bank debt
Banks have been reducing their reliance on wholesale funding by running off long-term debt, which has declined meaningfully as a percent of total assets—down to 9 percent vs. 15-20 percent pre-crisis. The shift away from wholesale funding and towards deposit funding is a positive when rates are low. However, over time, as rates rise, banks may have to issue debt and longer dated CDs to lock in funding costs (and in the case of long term debt, for regulatory reasons).