Banks’ efforts to boost margins
To boost interest margins, some banks are focusing on longer-term loans since they have higher yields. This increases the interest rate risk as rates rise. When the rates rise, these banks will still earn interest at the lower rate. Borrowing costs, on the other hand, will increase.
Higher yields are also available from more risky loans. The banks are adopting more relaxed lending standards in pursuit of higher yields. The resulting higher risks need to be monitored and controlled.
Another avenue to boost profitability is to focus more on fee-based revenues. Banks are set to benefit from the expected rise in interest rates.
Expectations of a rate hike
The US economy is now showing signs of improvement. Key indicators such as unemployment rate and GDP (gross domestic product) growth rate are at the Fed’s desired levels. The drop in the monthly US unemployment rate over the last two years is shown in the graph above. GDP growth rate has improved from the lows of 2008 and 2009.
The Fed is expected to raise the interest rate by mid-2015. This rate hike might be delayed, however, due to inflation rates going below zero over the last couple of months.
How a rate hike impacts performance
In an increasing rate environment, interest income produced by floating-rate loans increases. Income from short-term securities held in banks’ portfolios also increases since the banks shift these to higher rates. Banks typically raise the interest they charge for loans faster than what they pay on deposits. This gives an immediate boost to their margins.
A rate hike might also indicate an improving economy resulting in higher demand for loans. It also usually means rising income levels and lower defaults on loans. This results in lower charge-offs and loss reserves.
You may invest in banks, including Bank of America (BAC), Citigroup (C), Wells Fargo (WFC), and JP Morgan (JPM), through various financial sector-focused ETFs such as the Financial Select Sector SPDR ETF (XLF) and the iShares U.S. Financials ETF (IYF). The banking industry represents ~37% of XLF.