It is generally believed that higher interest rates are better for banks and, as a result, as the Federal Reserve tightens monetary policy, banks will be better off because their net interest margins (an indicator of the difference between what banks bring in and what they pay out in interest) will also increase.
There has been plenty of comment and analysis on this theme over the past 12 months as the Fed becomes more hawkish. One estimate highlighted in the International Business Times, released last September before the Fed’s first 25-basis-point increase; the top five banks could reap a $10 billion windfall in one year if the federal funds rate increased by one percentage point.
However, in an article earlier this year, I looked at research from the Federal Reserve Bank of Richmond and the Federal Reserve Bank of St. Louis, which arrived at the conclusion that while there is a relationship between net interest margins and interest rates, the relationship isn’t as clear-cut as you might expect.
The research shows that in the traditional banking model, liabilities are likely to be more interest-rate sensitive than assets due to the difference between the typical maturity of assets and liabilities, referred to as “maturity mismatch” as an article by the Richmond Fed explains:
“Some examples of bank liabilities are consumer and business deposits, which tend to have relatively short-term maturities. By contrast, bank assets — for example, business loans or consumer loans such as mortgages — often have longer-term maturities. Short-term rates track the fed funds rate more closely and are more volatile, so one would expect these yields to be the most affected by policy-driven increases in interest rates. If the policy rate increases, banks would pay out more in interest on their liabilities while the rates on their long-term loans would remain stable — effectively narrowing net interest margins.”
Banks are learning to live with low interest rates
In today’s world, the traditional banking model is fairly outdated, but the principle remains the same: funding costs are higher when market rates are high, which puts pressure on a bank’s net interest margin.
So, lower rates for longer may not be a complete disaster for banks. In fact, banks seem to be coping with the low rate environment extremely well according to their second quarter trading updates:
“So the question is, can we grow earnings without rates improving? We believe we surely can. We can do that by continued success on things like expense management, by keeping NII stable to growing, stable and growing fees, and continue to manage risk well and hold down our credit costs…Adjusted for market-related changes in both last year’s second quarter and this year’s second quarter, we grew NII by 400 million or 4% year-over-year. And that took place while the 10-year Treasury yield fell 86 basis points from last year.” — Bank of America’s (BAC) CEO Brian Moynihan on Q2 2016 Results
“Total loans were up … 3% from Q2 2015… (Ex mortgage run-off) loans are up 5% … on strong (new) mortgage and vehicle lending growth. Average vehicle loans are up 20% from Q2 2015.” — Bank of America’s (BAC) CEO Brian Moynihan on Q2 2016 Results
“We grew net interest income in the second quarter by 4% from a year ago, even with an 11-basis point reduction in NIM, and we continue to believe that we can grow net interest income on a full year basis in 2016 compared with 2015 in the current rate environment.”– Wells Fargo & Co.’s (WFC) CEO John Stumpf on Q2 2016 Results
“We had continued strong loan growth in the second quarter, up 8% from a year ago and 1% from the first quarter… (Mortgage) origination volume was $63 billion, up 43% from the first quarter, due to the seasonally stronger purchase market and increased refinancing due to lower rates. Applications were up 23% from first quarter and we ended the quarter with a $47 billion application pipeline, up 21% from first quarter and up 24% from a year ago.” — Wells Fargo & Co.’s (WFC) CEO John Stumpf on Q2 2016 Results
“It looks like rates will be flat at least in the front end at this point, at least for the majority of the year, if not the whole year. But you have seen already in the first two quarters that year-over-year we are up $1.4 billion, so we were doing better now on a combination of lower deposit bases, re-prices and also on strong loan growth. But if you annualize that, that would be too high. We are going to have some impact in NII of the lower tenure. It’s not significant but it will offset that to a degree. So we would expect our NII to be between $2 billion to $2.5 billion, up year-on-year, largely strong loan growth, lower re-price.” — JPMorgan Chase’s (JPM) CFO Marianne Lake on Q2 2016 Results
Smaller banks on the other hand, appear to be struggling:
“Net interest margin was 3.02%, 4 basis points lower than the prior quarter, which was in line with our expectations. The industry continues to face headwinds from low interest rate environment and the flatter yield curve, which became more pronounced at the end of the second quarter, and continues as we begin the third quarter… What we said was in quarter three, which is all we can see into, we have a three to four basis points prediction of NIM decrease. I have no idea what quarter four would be.” U.S. Bancorp (USB) Richard Davis on Q2 2016 Results
- Why Are Net Interest Margins of Large Banks So Compressed?
- Do Net Interest Margins and Interest Rates Move Together?
- Are Banks More Profitable When Interest Rates Are High or Low?