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In this article, I will analyze how increasing interest rates will impact the largest four banking stocks in the US (BAC, JPM, WFC and C) based on their recently released FY2013 results.

The interest rate outlook

In September 2013, the Federal Reserve published the following chart, displaying interest rate expectations of members of the Federal Open Market Committee (FOMC):

(click to enlarge)

(Source: Federal Reserve)

According to this chart, interest rates are expected to stay at current lows for the remainder of the year. However, the rise expected by FOMC participants thereafter is significant, from 0.25% today to 1% by 2015 and to 2% by 2016. Given the significant impact of interest rates to the banking business, it seems appropriate to take a look at the main banking stocks and their positioning in the face of such significant change.

The Impact on Net Revenue

For purposes of discussion, I will decompose Net Revenue into its components:

  • Net Interest Income is the difference between the interest earned on the bank's assets (loans) and the interest expense incurred to fund these assets. The Net Interest Income is positively affected both by increasing in interest rates (prices) and loans underwritten (volumes).
  • Non-Interest Income comprises fees and commissions earned on selling and administering financial products (loans, but also savings and capital markets products), and is therefore positively linked to volumes. An increase in interest rates, however, makes loans more expensive and depresses prices of financial products, therefore negatively affecting volumes, and in turn Non-Interest Income. As a result, Non-Interest Income is indirectly negatively affected by increasing interest rates.

As a consequence, a rising interest rate environment is on balance more favourable to banks with a higher component of Net Interest Income in their Net Revenue. If we look at the revenue composition of the top banks:

(Source: FY2013 annual reports / earnings announcements, author's analysis)

Based purely on this simple measure, it would appear that C is slightly better positioned than its peers to take advantage of increasing rates. However, merely looking at revenue is misleading; we need to take into account funding costs and how this impacts margins.

Funding Costs and Net Interest Margin

Breaking down Net Interest Income, we have that:

Net Interest Income = Interest Income - Interest Expenses

With increasing rates, both Interest Income and Interest Expenses are bound to increase. We are interested in the net effect, which will differ depending on how a bank is funded. In this context, the more a bank is able to rely on bank deposits, the better. This is because rates paid on deposits are both low and "sticky," i.e. banks adjust them either slowly or not at all in response to changes in market interest rates. We can measure the extent of deposit funding through the loan-to-deposit ratio (LDR).

(Source: FY2013 annual reports / earnings announcements, author's analysis)

The picture above tells us that all major banks have sufficient deposits to fund the entirety of their loan book, and then some. Therefore, an increase in market interest rates would allow an expansion of the Net Interest Margin across all four banks. The next question arising relates to the speed of re-pricing, i.e. how fast banks will be able to expand margins once interest rates rise.

Portfolio re-pricing

In the years since the financial crisis, we have seen borrowers engage in large volumes of debt refinancing to lock in low interest rates. We therefore need to look at the maturity profile of a bank's loans to determine how rapidly it will be able to hike rates. For the purposes of this article, I am using the simple ratio of mortgages / total loans to measure the proportion of long-dated assets:

* Does not include the mortgages in run-off portfolio

(Source: FY2013 annual reports / earnings announcements, author's analysis)

From this picture, we can see that JPM, BAC and C have ~75-90%+ of their loan portfolio in non-mortgage assets, which they will be able to re-price relatively quickly. As a traditional mortgage lender, this will take WFC longer to achieve.

Conclusion

BAC, WFC, JPM and C are all poised to benefit from the widely anticipated increasing rates environment. However, I find that C is slightly better positioned than its peer group through its higher exposure to interest rates and lower portfolio duration. Also, at a Price/Book Ratio of 0.85 at the time of writing, it looks relatively cheap with respect to peers. Therefore, while I currently hold BAC and WFC, I may also initiate a long position in C.

Source: U.S. Banking Stocks: Positioning For Increasing Interest Rates

Additional disclosure: I may initiate a long position in C.