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Summary

  • In the exit strategy to QE, the Fed will likely raise the interest on reserve (deposit rate) and engage in reverse repos.
  • Higher deposit rate will give a big boost the banks' bottom line.
  • Reverse repos will also give a boost to the banks' bottom line.

In an earlier article, I have explained the Fed's exit strategy to QE. Long story short, the Fed is reliant on two unconventional tools to control the money supply and the post-QE inflation, and they are:

i. The deposit rate (interest on reserves): The Fed will raise the deposit rate to provide incentive for banks to hold onto their excessive reserves. By keeping the excessive reserves in the banking system, the Fed can limit the expansion in the money supply and inflation.

ii. Reverse repos: Same idea as paying a deposit rate, the Fed will pay the banks a premium on reverse repos to temporarily reduce the monetary base.

The Fed is planning to used these two unconventional tools to help control inflation because a massive securities sale (the convention tool to control inflation) will destabilize the market.

The big question for us investors is then: how can we profit from the Fed's exit strategy?

Here, I am going to present my argument that the banks will benefit enormously from the Fed's exit strategy. And to begin, I am going to discuss how raising the deposit rate will benefit the banks.

First of all, let us note that interest payment on reserves can affect the profitability of banks. When the deposit rate is high, banks will earn more interest payment on their reserves, so their profits will also be higher. With this in mind, if the Fed does decide to raise the deposit rate, it will inevitability increase bank profits.

Now, how much could a change in deposit rate actually affect bank profitability? In order to address this question, I have prepared a mock scenario to gauge the effect of a deposit rate hike on bank profits.

Scenario: Assuming that the Fed raises the deposit rate from the current rate of 0.25% to 3%, how much would this affect Warren Buffett's favorite bank, Wells Fargo (NYSE:WFC), based on the bank's balance sheet in 2013?

(Note: I have chosen 3% because the Fed will have to raise the yield on the deposit rate to a number close to the yield on T-bills for this tool to work. And I believe that 3% is a reasonable estimate of the yield on T-bills in a better economy. Read my previous article for more detailed information.)

To answer the question presented in the scenario, we will need to compare two numbers:

i. The amount of interest payment that the bank would have received due to the deposit rate hike.

ii. The operating profits of the bank in that year.

As of December 31, 2013, Wells Fargo was holding $561 billion worth of its assets as cash and cash equivalent. Here, I am going to assume that most of this amount was deposited at the Fed as excessive reserve. So if the deposit rate was raised from 0.25% to 3%, the bank would earn an extra 2.75% on $561 billion, and that number totaled to about $15.4 billion.

So how does this number compare to the operating profit that Wells Fargo had earned in the same year? Well, the operating profits of Wells Fargo amounted to a total of $32.62 billion in 2013. Based on these two numbers, a deposit rate hike from 0.25% to 3% would have increased the bottom line of the bank by a hefty 42% ($15.4B/$32.62B = 0.42)!

Of course, in the real world, not all of the interest payment on reserves will become profits for the bank. Likely, some of it will be passed down to benefit the bank's depositors. But even if Wells Fargo were to realize only half the reserve payments as profits, its bottom line will still go up noticeably (+21%).

The take-home message here is that the banks have much to gain from a deposit rate hike.

Now, much like a deposit rate hike, the Fed would also increase bank profits if they use to reverse repos to control inflation. From my previous article:

In a reverse repo, the Fed temporarily reduces the monetary base by selling securities to banks, which the Fed will then repurchase at a higher price. To reduce the monetary base for an extended period of time, the Fed must continuously renew their reverse repo contracts, and thus, they will also need to pay out a constant stream of premiums. In effect, this is not much different than using the deposit rate to keep the money supply fixed; as in both cases, the Fed is more or less paying the banks (through an interest rate on reserves vs. a premium on the reverse repo) to keep their funds from leaking out to the loanable market.

To sufficiently control inflation through reverse repos, the Fed will likely have to significantly raise the premium paid to the banks on these contracts. Although it will be difficult to quantify how much more profits the banks will make from these contracts, as reverse repos are usually overnight and quite short in duration. Nevertheless, it is clear that the higher premiums on reverse repos will give a much welcomed boost to the banks' bottom lines.

Picking the Right Bank Stock to Hold

Now, knowing all this, which bank stock should we pick to reap maximum benefit from rising deposit rates and higher premiums on reverse repos?

Well, it's obvious that banks with the most reserves relative to their capitalization are likely to reap the most reward over this. The logic here is simple, the more reserves a bank holds, the more it is going to earn from the interest on reserves and from reverse repos.

Analysis: Which (Big Four) bank will benefit most from the Fed's exit strategy?

Cash and Cash Equivalent (in thousands of USD, March 31, 2014):

Wells Fargo: $576,592,000

JPMorgan Chase: $664,020,000

Bank of America: $618,013,000

Citigroup: $467,798,000

Capitalization (in USD, June 30th, 2014)

Wells Fargo: $276.84B

JPMorgan Chase: $218.05B

Bank of America: $161.63B

Citigroup: $143.08B

Based in the above information on the Big Four's reserves and capitalization, Bank of America (NYSE:BAC) holds the most reserves per dollar capital at $3.82, followed by Citigroup (NYSE:C) at $3.27, JPMorgan (NYSE:JPM) at $3.05, and Wells Fargo at $2.08. On this information alone, Bank of America will have the greatest upside (and Wells Fargo will have the least) when the Fed raises the deposit rate and the premium on reverse repos.

However, do note that there is a different level of risk and uncertainty in each of the four bank stocks. As Wells Fargo is perceived to be the best managed of the four, it commands a price premium over the other three bank stocks. Personally, I am long JPM, which I perceive to offer a good mixture of risk and reward. More aggressive investors may want to consider investing in Bank of America or Citigroup for the greater upside potential, while more conservative investors may want to go with Buffet's favorite bank, Wells Fargo.

Source: The Fed's Exit Strategy Will Line The Pockets Of The Big Banks