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.

interest rates

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.Interest rates

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.

Interest rates

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).

Credit spreads

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.

Interest rates

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

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).

Interest rates

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.

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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).

Interest rates

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