Bank Of America: 4 Rate Hikes Don't Guarantee Bigger Profits

| About: Bank of (BAC)

Summary

Investors have a fascination with Federal Reserve rate-setting policy.

The assumption is that higher rates means more money for banks like Bank of America.

This simply isn't the case; investors need to focus on trends elsewhere in bank filings.

As everyone who hasn't been living under a rock knows, the Federal Reserve hiked its targeted benchmark interest rate target to between 0.25% - 0.50% in December, starting the slow process of gradually returning interest rates to meaningful levels. A return to normal rates will take quite some time, but with four interest rates targeted for 2016 (which in and of itself is debatable), we could eventually see interest rates return to between 1.25% - 1.50% by the end of 2016. We last saw that interest rate in October of 2008, and not for very long as the Federal Reserve quickly cut the rates down to nothing.

Shareholders of banks like Bank of America (NYSE:BAC) have been waiting for this moment a long time, hoping higher rates set a trend of expanding net interest margin. At first, lower interest rates spurred by Federal Reserve policy were a windfall for banks, allowing them to pay out less to depositors while they still held higher-yielding assets on their books. All good things come to an end, however, and eventually the rates banks seemed to be able to charge on loans came down as well, leaving bank profitability metrics in a poor state.

Unfortunately for shareholders, there is no guarantee that rate hikes do anything at all to help bank profitability. Continued focus by shareholders on rate hikes is misguided, and shareholders need to pay more attention to other factors when evaluating their bank positions.

Bank of America Net Interest Margin and the Federal Funds Target Rate

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As we can see above, even though the federal funds target rate was lowered to basically nothing at the end of 2008, Bank of America's net interest margin did not change much between pre-recession (2006-early 2008) and at the early years of the recession (2009-2010). Bank profitability instead depends largely on two factors: the yield curve and risk-taking, not rate-setting of overnight loans by the Federal Reserve.

The Yield Curve

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*Source: Treasury.gov

Bank of America profits will not rise until its yield curve begins to steepen. As we can see above, the treasury yield curve has flattened considerably over the past five years, indicating part of the reason why we've seen margin compression at Bank of America.

Investors should keep in mind that while the treasury yield curve can be indicative of a bank's yield curve, in reality every single product will be different. The yield curve is all about the relationship between the supply of funds lent to the bank by depositors and the demand for loan products with longer maturities by borrowers. While the Federal Reserve can easily influence the short end of the curve via its target rate, it currently has no programs in place to influence maturities further out on the curve, on treasury products or other products like mortgages.

Banks want a steep yield curve. This allows banks like Bank of America to pay its lenders (depositors) a low amount of interest while simultaneously lending out those same funds at higher long-term rates to borrowers. More spread, more money.

We won't see the yield curve steepen again (and bank margins increase) until banks see higher demand for loans and banks are at the same time willing to make those loans (assuming inflation remains the same).

Risk Assessment Driving Bank Policy

Working at an investment bank, I've seen first-hand the burdensome nature of the current regulatory environment. While many of these rules have good intentions in reducing systemic risk within the financial sector as a whole, most of these rules are poorly targeted and unnecessary, increasing costs. Banks like Bank of America have responded to political and regulatory pressure by cutting back on higher risk areas where these new costs and political/regulatory risks simply outweigh the additional benefit.

We can extend lessons we all know from the stock market to the banks themselves. As an investor, you make a conscious decision on how much risk you are willing to take on via your asset allocation. If you're a risky investor, you're likely heavily invested in growth stocks with very little allocation to bonds or cash. If you're risk-averse investor, you've likely moved out of stocks and into safer assets like municipal bonds or treasuries.

Banks are taking the risk-averse route, and just like the above risk-averse investor can't expect outsized returns compared to their more risky counterpart, neither can banks. Regulatory policy needs to encourage healthy risk-taking, rather than discouraging risk-taking altogether. So while Bank of America's net charge-off ratio remains extremely low, this has been driven by moving out of risky products and making loans only to highly-qualified borrowers.

If shareholders want Bank of America (and other big banks like Citigroup (NYSE:C)) to make more money, they need to be willing to accept more risk. I'm not quite sure they are willing to accept that presently - past issues are too fresh in everyone's mind. Likewise, if regulators want Bank of America (and other banks) to not be so stringent with their requirements and to help boost the economy by lending, those parties need to accept the possibility more systematic risk.

Conclusion

Regular retail investors have attached far too much hope on rate hikes boosting Bank of America's profits. This simply is not guaranteed to be the case, and even if we have four rate hikes in 2016, I see no reason why Bank of America's profitability must implicitly rise as a result.

Big banks like Bank of America remain a poor buy in my opinion, and will continue to be so. The "Too Big To Fail" moniker is simply too burdensome, and the company will continue to have poor results until the regulatory environment changes and the economy makes a meaningful recovery, boosting demand for loan products.

Investors are instead better off being in regional banks like BB&T (NYSE:BBT) or Regions Financial (NYSE:RF), which are large enough to bear the burdensome fixed costs of regulation while at the same time being small enough to more quickly change and adapt their portfolios to any changes in the market.

Disclosure: I am/we are long RF.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.