It is just about stating the obvious but investors in banks need to seriously contemplate near-term interest rates environment. Banks' management have long-argued that the "lower for longer" rates in the U.S. and negative interest rates in many parts of the world is handicapping their profitability and messing about with its business model.
This is of course to a large extent true. The impact of low interest rates is certainly profound on banks' profitability and business models. As such, analyzing banks without due consideration to interest rates is probably as futile as investing in airline stocks and disregarding the price of oil.
Interest rates are a key input to the profitability and valuation models but it is thwart with complexity and co-dependencies - the most obvious one is the familiar credit cycle (which it seems most young investors would probably not vividly recall). The current recovery certainly feels different in terms of growth rates and longevity.
Why are interest rates so important for banks?
There are multiple and intricate reasons for the importance of interest rates, many of which as alluded to above are not mutually exclusive - I will list out the large moving parts below and explain (hopefully in a simple manner) their significance.
Bank's Liquidity buffers are placed with the Fed and other safe short-term liquid assets (in industry lingo, this is known as High Quality Liquid Assets (HQLA)). This is effectively a liquid asset portfolio that safeguards the banks from a panicked deposit run (à la Lehman Brothers event) - the large U.S. banks hold as much as $400-$600 billion of HQLA. The simplest way of thinking about it is as a 'liquidity tax' - i.e. the banks are forced to keep a low-yielding asset portfolio that it can readily liquidate in a crisis time which clearly depresses its net interest margins.
So what happens when the Fed raises short-term interest rates?
The portfolio yield re-prices higher immediately (think about short-term rates) whilst the liability side (i.e. deposits) will re-price much more slowly and to a lesser extent (and each bank has estimated the liability re-pricing in line with its unique business mix).
Consider Citigroup's HQLA portfolio as of Q1 2016:
Citi has around $400 billion HQLA portfolio and is well above minimum requirements with LCR of 120% (which incidentally is a very conservative approach to managing liquidity). Now, lets assume the Fed raises short term rates by 100 basis points - one would expect an immediate re-pricing of large part of its U.S. dollar portfolio (over 70% of assets) and given the short-term nature of securities most of that 100 basis points will flow right through to the revenue line. The positive revenue impact will be offset somewhat by liability re-pricing - i.e. Citi will likely need to increase the rates it pays on its deposits to a certain extent. The key point though is that liability re-pricing will be substantially lower and slower than asset re-pricing.
The yield curve and maturity transformation
It is banking 101 - banks are in the business of maturity transformation where they borrow short and lend long and thus prima facie should benefit from a steepening yield curve.
Unfortunately as the chart above demonstrates the flattening of the yield curve at the beginning of 2016. For BAC the damage was quite pronounced in the FAS91 accounting adjustment with a $1.2 billion hit to earnings:
So what does it mean for investors ?
One should not only watch the absolute levels of interest rates - the yield curve is just as important for many retail-focused banks (but more on that later).
One observation from my side - it seems to me that many of BAC's investors (at least on Seeking Alpha) are mostly focused on the Consumer businesses. In this recent interesting article, the author focuses on BAC's investment case based on its Consumer business and cross-sell potential (comparing it to Wells Fargo).
It is a nice analysis for sure - but BAC is not WFC. The facts are the facts, and the consumer businesses in BAC are much smaller than the wholesale businesses and trapped capital.
As such, there is very little doubt on this point - the investment case for BAC largely hinges on its commercial and corporate businesses (including $37 billion of capital allocated to its Markets business which by itself is larger than the $29 billion allocated to BAC's consumer).
The more subtle point on rates though is that the trading businesses are also likely to materially benefit from increasing rates. The expected benefit should arise in the context of increased demand for hedging instruments (due to interest rates volatility), bond trading (as secondary trading volume increase driven by investors, pension and hedge fund portfolio changes) and FX volatility (monetary policy divergence).
Clearly, as opposed to a banking accrual businesses, to estimate the potential benefit of rates on the trading businesses is near-impossible (it depends on so many factors and broader industry dynamics). Naturally though, the direction of travel should be largely positive for the money-center U.S. banks. It is an area that most analysts seem to ignore or discount heavily - I personally believe that there is a huge upside optionality in these trading business despite (or in spite of) the new regulatory regime.
Should we listen to the bond king?
When it comes to interest-rates, I tend to listen to the fixed income guys - frankly, it is not my expertise.
The Bond King, Mr. Bill Gross, certainly caught my attention in this recent Bloomberg interview following the April jobs report.
As can be seen in the above video, the Janus funds manager's perspective is a unique one:
- Short-term rates must rise to save the business model of pension funds and insurance companies (give savers a break at the money markets).
- QE4 must come back to reduce volatility and paying for fiscal spending ('helicopter money').
Bill's argument is simple and powerful - short-term rates must be raised and quicker than the market expects. The Fed gets it but Mr. Market (and the 2-year) is mis-pricing it. At the same time QE4 will have to be employed to manage volatility on the long-end and ensure credit spreads do not widen too much.
If Bill is right and the yield curve will flatten further (or not steepen much) - this will of course have a profound impact on the banks' profitabiity.
While I don't always subscribe to the Bond King's sentiments - in this instance, I can certainly can see the rationale. In fact, the recent April FOMC minutes and yield curve behavior, so far indicate that Mr. Gross is spot on.
Let us consider BAC and Citi in detail under the above scenario.
BAC sensitivity at the long end
BAC's latest 10-Q provides some useful insights.
As can be seen clearly from above, BAC is sensitive to both the long-end and short end. The ideal scenario of a parallel shift of 100 basis points, is estimated to yield ~$6 billion on pre-tax income. Out of $6 billion slightly less than half is attributable to short-term rates - having said that, it is also very clear that BAC is also extremely sensitive to long-term rates which largely explains its trading patterns in recent times.
For Citi it is the short-end that matters
Similar disclosures are provided in Citi's 10-Q:
It is quite clear that Citi is not that sensitive to the long-end - it is the short end that matters (main reason is its asset mix that is slanted towards wholesale assets and credit cards with much less focus on mortgages).
Which bank is better positioned if Bill Gross is right?
BAC, in recent years, has always traded as the most interest-rate sensitive banking stock and rightly so. Investors, though, should be cognizant of the fact that not all rising interest rates environments are the same. The scenario Mr. Gross is sketching out is an increase in the short-end coupled with lower/stable rates on the long end - in other words, a flattening to stable yield curve.
This scenario may not benefit BAC as much as investors hope and expect.
For Citigroup on the other hands, it is really all about the short-end as over 90% of the benefit is controlled by the Fed's hands.
The bottom line
Interest rates are especially important for banks but it is a much more complex and multi-dimensional picture. The analysis above focuses on interest rates movements assuming all else is equal. This is clearly not the case - investors should look out for a range of factors including the broader macroeconomic settings, management quality, capital position, cost efficiency, net credit losses, business mix, competitive dynamics and regulatory developments.
In my career, I can hardly recall a more complex period to analyze banks than currently - there are many potential pitfalls along the way. Having said that, this is also where the opportunity is to deliver exceptional returns (on the long and short side).
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Disclosure: I am/we are long C, BAC.
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.