With investors largely expecting the announcement of a 25 basis point increase in the discount rate after the December FOMC meeting, it's a good time to take a look at the impact that a rate hike will have on both national banks and smaller savings & loans. It's the general consensus that any rise in rates will greatly improve the banking sector's profitability, but is this true for all banks?
It's obvious that with larger national and regional commercial banks, a rising rate environment is beneficial. These banks have massive cash holdings from deposits and are required to keep a percentage of those assets at the Federal Reserve in order to offset liabilities. Fortunately, the Federal Reserve pays interest on that cash. Currently, for liabilities greater than $110.2 million, the reserve requirement is 10% of liabilities. This means that even a small increase in short term interest rates could mean millions in increased yield for these banks. In addition, long term yields will likely edge up, making loan profits substantially more attractive.
However, the story for smaller savings & loan corporations is a completely different one. Because these smaller banks do not have a large deposit base to begin with, a large reserve requirement greatly hurts profitability. For this reason, the Federal Reserve sets the requirement at 3% for liabilities between $15.2 million and $110.2 million. While this helps overall profitability, it means that an increase in short term interest rates will not have the same marginal benefit that it will have on larger banks. In fact, an increase in short term rates may even be negative for saving & loan banks. To begin with, S&Ls already pay higher interest rates on deposits. An increase in short term rates will put a lot more pressure on that deposit rate. By Regulation Q, S&Ls are permitted to pay a rate on deposits that is 50 basis points higher than other banks. In a rising rate environment, these banks will likely have to take advantage of regulation Q in order to attract deposits. This means that the cost of borrowing is greatly increased and, as a result, profitability is hurt.
Furthermore, the vast majority of loans held by S&Ls are either individual mortgage loans or mortgage backed securities, which are tied to long term interest rates. The opinion of many on Wall Street is that an increase in short term rates will lead to a flattening of the yield curve. This is to say that an increase in short term rates will not have a large impact on long term rates. Leading up to the anticipated rate hike, treasuries have not been dramatically affected and, judging by the last tightening cycle, we will likely see the flattening that many expect. This compression of the margin between lending rates and the cost of short term borrowing will lead to greatly decreased profitability in the savings & loan industry. Eventually, when long term rates do start to rise, it will take banks a considerable amount of time to change their loan mix. A large number of loans were made during the past few years in a low interest rate environment, so the benefit will be delayed.
The historical positive for many banks in rising rate environments is that rates generally only rise when the economy is performing well and improving. During this cycle, that point is arguable. Slowing in the Chinese economy has left many investors very fearful about global economic growth and a lack of inflation in the U.S. has led to investors questioning the real state of the U.S. economy. The possibility of a still weak U.S. economy could spell trouble for cyclical financial stocks.
Another factor that places savings & loan banks below their larger banking peers is their dependability on housing. Many economists see the possibility of a bubble forming in selected housing markets like the San Francisco area. The Case-Shiller San Francisco Home Price Index has increased more than 65% since January 2012 and is approaching the pre-crash 2007 highs. The mortgages issued and held by S&Ls are secured by the value of these same homes. If the values of those homes are overstated, then this could mean trouble for S&L banks. If the possible bubble eventually bursts, and home owners are unable to pay their mortgages, then these banks will be stuck with assets that represent a fraction of the value of the bank's initial loan. While other banks may hold mortgage backed securities, S&L banks will be hit the worst.
Investors must be cognizant of the fact that not all financial stocks will benefit equally from rising rates. While large national banks stand to do well when rates rise, smaller savings & loan companies may be negatively impacted. I would not look to initiate a position in an S&L bank in this type of environment.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
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.