Interest Rates are a Two-Edged Sword
Bank investors are discovering rising rates are a two-edged sword. While revenue may increase, rising rates have the potential to do serious harm to other parts of the banker's business model.
The purpose of this post is to identify six specific challenges rising rates create for bank profits by highlighting verbatim comments made last week by bank executives during earnings calls.
In addition, a secondary goal is to introduce my next SA post which will examine select banks that clearly benefit from rising rates. Included in that post will be Commerce Bank (NASDAQ:CBSH) based in Missouri that reported earnings last week.
1Q Bank Earning Reports
The following banks reported 1Q earnings and held earnings calls with analysts last week: J.P. Morgan Chase (NYSE:JPM), Citigroup (NYSE:C), Wells Fargo (NYSE:WFC), PNC (NYSE:PNC), First Horizon Bank (NYSE:FHN), and First Republic (NYSE:FRC).
In the Bankers' Own Words: Interest Rates and Profits
Here are the challenges:
First, anyone who thinks rising rates help bank profits is not paying attention to both sides of the balance sheet.
Let's get back to basics: Banks have loans (assets) and deposits (liabilities) on their balance sheets.
Citibank's CEO, Mike Corbat, was asked during the earnings call last week about the revenue benefit the bank realizes with every 25 basis point (NYSE:BP) increase in rates. Here is what he said:
"25 bp rate hike should impact revenue by about $100 million for each quarter that it's in effect. That's rough math. That's all going to dependent on where you are with deposits."
Sounds good. Rates go up, Citi makes more money.
Well, not so fast. Corbat reminded his audience that deposits matter. How much do they matter?
We need to go to Citi's 1Q 2017 8K to answer this question.
In the 4th quarter of 2016 Citi generated total interest revenue of $14.44 billion and incurred an interest expense of $3.28 billion. One quarter later - despite the "benefit" of two rate hikes (12/15/16 and 3/15/17) - interest revenue actually declined slightly to $14.42 billion while interest expense increased nearly $300 million (9%) to $3.57 billion.
The effect: Net Interest Income ("NIM": Interest revenue minus interest expense) for Q1 2017 fell from Q4 even after the bank enjoyed the benefit of the December 2016 25 bp increase for a full quarter. Citi's NIM was 2.74% for Q1 2017 versus 2.79% one quarter and two rate hikes earlier.
Here's one more Citi number from the 8K: interest expenses on deposits and funding were up 21% Q1 2017 compared to Q1 2016 while interest revenue for the same time was up 2%.
But Citi is far from alone in not seeing an expanding NIM so far in 2017. As Wells Fargo's first quarter 8K shows, the bank's NIM quarter over quarter is flat (2.87% for each quarter) and actually down 3 bp from Q1 2016.
In Wells' case interest revenue in Q1 actually increased, up $168 million. However, on the flip-side, interest paid on deposits quarter over quarter increased $270 million. Net-net the bank saw NIM fall $100 million.
What did Wells' execs have to say about this during the 1Q earnings call?
They talked about "deposit beta", a term bankers use to calculate the relationship between deposit costs and interest rates movements.
When asked about deposit betas, here is what Wells' CFO, John Shrewsberry, had to say:
"It's hard to parse each piece… deposit prices didn't react the way we had originally modeled them. But we have to imagine how the market pricing will react with each subsequent move."
Shrewsberry is being honest in acknowledging Wells' "deposit beta" models are imperfect. A new generation of bankers are just now learning that calculating deposit flows in a rising interest rate environment is not as easy as they perhaps thought. It is still too early to calculate with any precision the impact rising rates will have on deposit costs. If history is any indication, however, investors can expect deposit costs to track step-by-step with the direction of loan rates.
Second, corporate treasurers and big depositors are savvy
We will stay with the Wells Fargo earnings call last week.
An analyst asked the bank's CEO, Tim Sloan, about the bank's non-interest bearing deposit balances which averaged $364 billion last quarter.
Sloan noted that the $364 billion in non-interest DDA were split evenly between consumers and commercial/small business customers. This distinction is important and here's why.
Corporate treasurers are not dumb. When rates rise the corporate treasurer will make sure the company benefits.
CEO Sloan got into the details about how this works. He described the "Earnings Credit Rate (ECR)" that banks give their corporate customers for deposits kept at the bank.
Corporate deposits earn a "credit" (applied to fees) based on prevailing interest rates that is then used to offset the cost of deposit services incurred by the corporate customer. The higher the rate (typically based on Treasuries), the higher the credit the corporate customer earns to offset bank deposit fees.
In practice, think about Taco Bell. Every day Taco Bell stores around the country sell tacos and take in cash. Every day either an armored courier picks up the deposits and takes them to the bank or the store manager drops the deposits into a night drop or takes them to the teller counter for deposit. All the corporate customer's activities incur fees that are tallied up monthly. At the end of the month the fees are reported and billed to Taco Fee.
When rates rise, Taco Bell's deposits earn higher ECR, and as a result, more fees are offset. The effect? Deposit fee income falls. And that is exactly what happened at Wells Fargo last quarter and will continue to happen as rates go up.
Returning to the 8K, Wells' deposit fee income dropped from $1.36 billion to $1.31 billion quarter over quarter.
Bank investors must understand that when rates go up, fees are likely to decline, especially for banks with big commercial business activities.
Yet there is even more insight about rising rates that investors can learn from the Wells' earning call last week.
While Tim Sloan acknowledged that the bank had not engaged in"programmatic" increases in the rates paid for deposits, Wells did increase during the quarter the interest paid"for categories of customers based on relationship, based on the value of the deposits, etc."
This is important for investors to understand. Wells' best depositors get non-published rates for holding deposits with the bank. Let's be clear, though Wells has an absolutely terrific deposit base, especially in valuable non-interest bearing DDA, the bank will pay up for deposits from its best depositors.
Third, most bankers need deposits as much as they need loans and they will pay up for needed deposits.
Another bank that reported earnings last week was Tennessee's First Horizon (trade name: First Tennessee), the nation's 51st largest bank. Unlike some of the megabanks like J.P. Morgan Chase or Wells Fargo, First Horizon's balance sheet is similar to the vast majority of banks in the U.S. which have loan to deposit ratios greater than 80%.
For banks like First Horizon there is little wiggle room when it comes to holding on to deposits in a rising interest rate environment. Without deposit growth, there is no loan growth.
During the First Horizon call last week an analyst observed that "it feels like the pace of the cost of the increase in deposit cost is picking up."
The bank's CFO, William Losch, acknowledged that deposit costs had increased during the quarter, noting that the bank's interest costs on deposits were going up for two reasons.
First, like Wells Fargo, the bank's commercial DDA - which constitute 50% of the bank's deposits - have a "higher beta" and when rates go up, so too will interest paid on commercial DDA.
Second, Losch said "on the consumer side" the bank ran special "promotions" that "built several hundred million promo balances that will then reprice back down in six months." Losch went on to describe the attraction of promotional pricing because it allows the bank "to build balances because it doesn't reprice the entire portfolio."
He assured his questioner that the higher cost of deposits is a "timing issue" and that "we are managing deposit costs well."
With all due respect, I doubt Mr. Losch is correct about the "timing issue." First Horizon's promotional deposit pricing allowed it to capture what I call "hot money." Banks have been running these schemes as long as I can remember.
But here's the problem: hot money deposits are ephemeral - here today and gone tomorrow. In six months First Horizon will discover the hot money it recently attracted from promotional pricing will not remain in the bank unless the bank continues to pay a premium interest rate.
Stephen Alpher, an SA editor, posted on April 10 a piece entitled "Higher Rates and the Banks - Depositors to be Heard from as Well."
The post generated 23 comments. Perhaps the most interesting comments were the ones written by readers recommending how savers can earn higher interest rates by leaving deposits at credit unions, Vanguard Prime Money, Synchrony, Goldman Sachs Bank, Ally, and American Express.
In addition to the institutions mentioned, savers might also want to consider Pure Point Financial which is paying 1.25% APY for online savings of $10,000 or more. That's as good a rate as I can find for overnight, FDIC-protected deposits. My purpose in mentioning Pure Point is not to promote their offer but to highlight how banks are devising different strategies to attract vital deposits.
Read the fine print of Pure Point's newspaper advertisements and you will discover that Pure Point is a "division of MUFG Union Bank, N.A." Californians know Union Bank is a Japanese-owned bank based in California. It is also the 23rd largest bank in the US.
Union Bank wants deposits so badly that it has created a special online savings account - under a different brand - to get those deposits. Why a different brand? Here is a possible answer: the bank does not want to cannibalize existing low-rate Union deposits held in its California branches. Likely it is hoping to skim off hot money across the US to fund assets.
(Question for SA readers in California: Is Pure Point running advertisements in California market newspapers? I suspect not, but would like to get confirmation.)
Pure Point/Union Bank is yet another example of how rising rates have forced some banks to pay up for deposits.
Fourth, there is intense competition for high quality loans leading to pricing pressures.
In my recent book about bank investing I highlighted First Republic. If you are not familiar with First Republic, it is a niche bank headquartered in San Francisco and focused exclusively on private banking and wealth management.
It is the former bank subsidiary of Merrill Lynch which Bank of America acquired in January 2009. First Republic was taken private in June 2010 by its management team led by CEO, Jim Herbert. The bank then went public six months later. As I describe in some detail in my book, Herbert and team have done a masterful job creating shareholder wealth from the get-go.
Anyway, during the investor call last week First Republic executives offered two particularly important insights about the impact interest rates are having on bank profits.
The first was related to deposit costs. Gaye Erkan, the bank's Chief Deposit Officer, noted that First Republic's cost of deposits is up only 1bp despite three Fed rate hikes. She went on to say that the bank's superior deposit gathering capability is tied to the "relationship nature" of the bank's overall strategy.
In contrast to Pure Point which is forced to treat deposits as a commodity, First Republic's unique strategy allows the bank to gather deposits based on the bank's superior customer service model. Erkan went on to forecast that "we do expect to lag meaningfully" other banks' cost of deposits if and when rates continue to go up.
One more thing on Erkan: did you notice her title? Chief Deposit Officer. Today this title is rare in the industry. After a few more rate hikes you can expect to see this title to become as common as chief financial officer.
But there is another takeaway from First Republic's earning call last week. Let's shift the analysis to the other side of the balance sheet: loans.
Mike Selfridge is the Chief Banking Officer at First Republic. Last week he observed that "we won't compete on … credit standards but we do compete on pricing to acquire new high-quality relationships and retain existing ones."
Selfridge's declaration about competing on price has serious implications to investors who think banks reap all the advantages in a rising rate world. He is telling investors that the bank's NIM may not expand as fast as investors might expect because competition is forcing banks to price the best loans close to the bone. This is not a new phenomenon for bankers but a challenge that becomes more acute in a rising rate environment.
The fact is that the best borrowers have many alternatives and ultimately competitors are willing to sacrifice margin to secure a great loan, especially if it brings an opportunity to secure a relationship with a wealthy family or strong business. First Republic is not unique in taking this position.
Competing on price can backfire if a bank has too many long-term fixed rate loans on their books. The S&L industry learned this lesson back in the late 1970s and early 1980s.
While there is no risk that the commercial bank industry is headed down a similar path, time will tell if some banks have been too aggressive in using fixed rate pricing to attract and keep loans. Absent effective interest rate hedges, such banks could be in trouble if rates rise rapidly.
Fifth, rising rates dampen loan demand.
The most disturbing short-term trend so far coming out of Q1 earnings is the slowdown in loan growth. While First Republic's Selfridge described the first quarter as "the best quarter ever" for the private bank lender, other banks reported tepid loan demand.
Comparing March 31, 2017 loans to December 31, 2016 reveals that the following banks actually experienced a decline in loans during the recent quarter: Wells Fargo, Citibank, J.P. Morgan Chase, and First Horizon.
While Jamie Dimon, CEO and chairman of J.P. Morgan Chase, said "I wouldn't react in the short-term in our loan growth," the trend for 1Q raises a serious question whether rising interest rates are beginning to dampen loan demand. Dimon went on to note that "credit card looks ok, mortgage is obviously affected by interest rates, auto is obviously affected by auto sales, and middle market was… slow but okay."
Wells Fargo executives during their call discussed the slowdown in mortgage lending - related to rising interest rates - and auto lending, related to concerns about credit quality.
The biggest drop in loans quarter over quarter among banks reporting earnings last week was at First Horizon, where loans fell -2.5% quarter over quarter as reported in its 8K. The bank's CEO, Bryan Jordan, noted in his introductory comments that "we did see some expected volatility in our mortgage warehouse lending business… impacted by interest rates."
Like Wells, First Horizon's mortgage lending slowed as rates rose.
Later in the call when asked about "the lack of loan growth," Jordan had this to say:
"It would be hard to put a pin in and say, it's exactly this, because it's different in every situation. I think there is clearly some expectation that built after the election that regulation, healthcare, maybe taxes, more optimistically would have some impact, and whether that softened or not I don't know but I think people are looking at that and paying attention to it. But I wouldn't say that that's the single determinant."
The bank's CFO, William Losch, went on to point out that "two particular areas… that have moderated, mortgage and mortgage lending… But also there is a lot of discussion about…. commercial real estate…. particularly multifamily across the industry."
Over the next few weeks it will be interesting to see if other bank executives talk about a slowdown in not only the home lending business because of interest rates, but also commercial real estate.
Sixth, rising interest rates means more banks are likely to hold cash over securities that pay greater interest.
Investors may not know the role of a bank's Asset-Liability Committee ("ALCO"). The ALCO is typically made up of a bank's senior-most executive officers and is responsible for reporting to the board on how the bank's balance sheet is positioned.
When Wachovia Bank nearly failed in 2008 and got taken over by Wells Fargo, the root cause was the failure of the ALCO and board to properly assess the risks associated with the bank's liquidity position. Liquidity refers to high quality assets that are either cash or can be converted quickly to cash. The most liquid of assets is cash itself.
Since the Financial Crisis banks have held a lot more cash on their balance sheet as a means to mitigate liquidity risk. When rates rise, banks are tempted to redeploy the cash into longer dated securities that pay higher interest rates. The problem with this strategy is that rates may continue to go up, and therefore, as rates rise, the securities lose value.
Fear of rising rates explains at least one reason banks have built up large cash positions. As of the end of the 1st quarter J.P. Morgan Chase held $524 billion in high quality liquid assets.
To understand how bankers should think about the relationship between cash and interest rates, consider these insights Wells' CFO gave his audience during the call last week"
"And now we have to ask ourselves again, are we going to be lower for a while, lower for longer or are we still waiting for a shoe to drop for there to be a big backup in rates? … And the tradeoff of course is carry in the short-term. We had positioned ourselves very heavily lower for longer in an outspoken way before the election. And now we are contemplating what profile to maintain going forward…. So if we are in a rising interest rate environment, one way for us to preserve that - one way, there are others - is to delay investments in securities we would otherwise make."
Shrewsberry nailed it. The framework he described is exactly how an effective ALCO member should think about the tradeoffs between short-term profit maximization and long-term prudent balance sheet management.
"And I am hedging at that only because we have seen a lot of growth in the cash balances. You can see our cash is almost 10% of our balance sheet, at this point in time. And obviously, as that cash grows, it does impact the denominator of the NIM calculation and you get very little earnings off of cash, especially cash that we would have over in, say EMEA. So I'll hedge a little bit on NIM, going forward, but it should be up slightly. But I'd ask you to focus a little bit more on net interest revenue growth."
Frankly, I question Corbat's last sentence in the comments above. He asked analysts to "focus a little bit more on net interest revenue growth."
No, investors must see the whole picture.
Last week's earnings calls reveal six reasons bank earnings are challenged when rates rise:
1. Deposit costs also rise.
2. Corporate treasurers use rising rates to offset deposit fees.
3. Banks with a lot of loans cannot afford to lose deposits.
4. Competition for good loans means banks will compete on price which puts pressure on the Net Interest Margin.
5. Rising rates hurt loan demand.
6. Banks worry about liquidity and hold more cash.
Finally, my next post will examine the specific balance sheet and income characteristics of banks that showed material benefit in the first quarter from higher interest rates. Check out Commerce Bank's recent 8K released last week if you want to get a jump on my analysis. You can also read my September 2016 post, 4 Banks Positioned for Rising Interest Rates.
Disclosure: I am/we are long JPM, FRC, CBSH. 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.