Big U.S. banks prepare to make even more money
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An expected rise in interest rates over the next year will help the largest U.S. banks earn billions of dollars in additional net interest income, setting up their cheap stocks for what could be a stellar run.
You might be surprised to be reading anything positive about big banks, in light of Bank of America Corp.’s BAC, +0.06% $16.65 billion mortgage settlement with the Department of Justice and several states last week. The epic settlement followed a similar $7 billion settlement by Citigroup Inc. C, -0.52% in July and a then-record $13 billion settlement by J.P. Morgan Chase & Co. JPM, -0.25% last November.
While these companies still face continued investigations and litigation over their mortgage lending and securitization activities heading into the housing blowup of 2008, as well as several regulatory investigations of Libor reporting and foreign-exchange trading, it appears that the period of huge settlements is over.
Looking ahead, 2015 promises to be a fresh start for the industry, as the interest rate environment improves and the banks move past the settlements.
The Federal Reserve has kept the short-term federal funds rate locked in a range of zero to 0.25% since late 2008, in an effort to increase loan demand and jump-start the economy. This policy and the “QE3” bond purchases that will end this year seem to have worked, with the U.S. economy expanding at a 4% annual rate during the second quarter and continuing to add over 200,000 jobs a month.
But the debate at the Federal Reserve has now shifted to the timing of interest rate increases. Most economists expect the federal funds rate to begin climbing in the second half of 2015, but it could well happen sooner than that.
For most banks, the extended period of low interest rates has become quite a drag on earnings. Net interest margins — the spread between the average yield on loans and investments and the average cost for deposits and borrowings — are still being squeezed, since banks realized the bulk of the benefit of very low interest rates years ago, while their assets continue to reprice downward.
As part of their risk management, banks run models to estimate the effect of changes in interest rates on their net interest income. Banks can show the effect of a parallel change in long-term and short-term rates based on an instantaneous change, or “shock.” They can also illustrate the effect of a gradual rise over a certain time period, or “ramp.”
Some banks provide estimated changes in dollar amounts, while others give percentage estimates. Some take a much more complicated approach in their public filings, trying to gauge the effect of rising rates not only on interest income, but on mortgage-banking volume and revenue.
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