The lower the interest rates, the lower the margins
Interest rates (TLT) have been at record lows since the financial crisis hit in 2008. Low interest rates lead to lower net interest income for banks. Banks typically “lend long and borrow short.” This means that the maturity of a bank’s loan portfolio typically exceeds the average maturity of its deposits. When interest rates start to decline, funding costs fall faster than net interest income. This leads to higher margins. However, net interest margins fall when interest rates remain lower for a longer time and loans are repaid or renewed. As the yield curve steepens, these margins grow. This improves banks’ profitability. Banks with more commercial loans, which often have floating rates that rise with the Fed’s rate, will profit the most from higher interest rates. However, rates on mortgages are often fixed for many years. Read An ‘Appropriate’ Rate Hike: Time to Bank on the Financial Sector? for more on how interest rates impact the financial sector.
Major banks with high interest-related income like Wells Fargo (WFC), Bank of America (BAC), JPMorgan Chase (JPM), and Citigroup (C) have been struggling with compressed margins. They’re eagerly waiting for a rate hike. Since the financial crisis of 2009, the Fed has kept its fund rate at near-zero levels. Bank of America and Wells Fargo both have large loan portfolios. They derive most of their total income from interest-related income.
The FOMC meets next week to decide on its policy rates. In this series, we’ll compare two of the largest US banks—Bank of America and Wells Fargo—on the basis of their interest rate sensitivity, profitability, oil and gas exposure, analysts’ ratings, valuations, and more. Let’s delve into their interest rate sensitivity first.