U.S. banks squeezed by interest rate disparity
While the European Central Bank embarks on its quantitative easing program and lowers bond yields throughout the euro zone, consensus is building across the pond that 2015 could finally be the year interest rates rise in the United States. Fed Fund futures markets and Fedspeak soothsayers agree that the Federal Reserve will, more likely than not, finally raise short-term interest rates by October.
U.S. banks have been preparing for the Fed’s move for some time. The question of whether higher interest rates are good for the banking sector depends on a couple of more specific inquiries: which rates are rising and why?
The distinction is important because banks rely on borrowing at cheap, short-term rates and lending money for longer periods at higher interest rates, generating a nice net interest margin (NIM). If — as anticipated — longer term rates rise as the Fed raises short-term rates, it bodes well for banks. Under that scenario, banks could reasonably expect an increase in net interest margins by lending at higher rates while experiencing a proportionately smaller increase in borrowing costs due to the fact that a decent portion of their borrowings are from customer accounts (such as checking accounts) that don’t bear interest.
Net interest margins of major banks
Troublingly, while short-term rates have risen in anticipation of Fed tightening, longer-term yields have reversed course and fallen in recent months. A flattening yield curve can indicate poor long-term growth prospects or recession on the horizon. Indeed, the spread between 10-year and 2-year Treasuries is nearing levels not seen since the global financial crisis:
Spread between 10-year and 2-year Treasury yields
This relative flattening of the yield curve bodes poorly for bank NIMs, which already registered record lows in the fourth quarter of 2014. Since 2010, net interest margins have come down substantially for U.S. banks, especially among the largest. Wells Fargo’s 12 month trailing NIM dropped from 4.2 percent at the end of 2010 to its lowest-ever recorded, 3 percent, at the end of 2014. JPMorgan’s, in the same period, fell from 3.1 percent to 2.1 percent.
The direction of rates isn’t the only thing affecting bank margins – increased regulation (Basel III, Volcker Rule) and rising legal compliance expenses have added to funding and operational costs – but it is a serious concern for bank executives. Brian Moynihan, chief executive officer at Bank of America, addressed this issue last week at the World Economic Forum. He remarked that if the Federal Reserve raises short-term rates merely “because they have to fight off some unexpected outcome, a spike in inflation, that’s not good.”
A decision to raise rates due to strong U.S. economic growth, on the other hand, would indicate a friendlier and more profitable world for lenders. As 2015 progresses, the shape of the yield curve should provide a decent barometer for banks’ lending prospects going forward.
Flattening U.S. Treasury yield curve