Several factors impact the banking sector’s performance. These include:
- movements in interest rates, the shape of the yield curve, and net interest margins
- the state of the economy gauged by GDP growth, employment growth, inflation, consumer spending, savings, and income levels
- changes in technology
- changes in regulatory requirements
- asset quality as measured by delinquency and charge-off rates
Previously, we discussed banking regulations. Now, let’s discuss the other key indicators and trends for the sector.
Banks and interest rates
Banks charge interest on loans that they write and pay interest on deposits they receive. So, interest rate changes significantly impact banks’ performance. In July, the Federal Reserve cut the federal funds rate by 0.25 percentage points. Notably, this marked the first rate cut by the Fed since the 2008 financial crisis.
Lower interest rates typically squeeze a bank’s NIM (net interest margin), which is a bank’s net interest income expressed as a percentage of its total interest-earning assets. NIMs squeeze because when the interest rates fall, the interest earnings on floating rate loans also fall. Additionally, lower rates result in the refinancing of existing loans by the borrowers, which reduces the interest that banks earn on these loans.
Notably, lower rates also reduce a bank’s borrowing costs and the interest it pays on deposits. Typically, borrowing costs don’t fall proportionally. Generally, banks find it difficult to boost margins using deposit pricing strategies in a lower rate environment.
The shape of the yield curve
The shape of the yield curve is a closely followed indicator. Among other things, it indicates the market’s expectations of future interest rates. While the short-term interest rates are set by the Federal Reserve, longer-term rates are determined by the market.
A rise in longer-term yields generally indicates an improving economy. On the other hand, expectations of lower economic growth generally result in a flattened yield curve. Plus, long-term yields are affected by long-term inflation expectations and the central bank’s activities.
Generally, a yield curve slopes upward because the yields on longer-dated securities are generally higher than those of shorter-dated securities. Concerns about global economic growth contribute to the flattening of the yield curve, which could lead to the inversion of the yield curve.
A yield curve, or a part of it, becomes inverted when the yields on the shorter-dated securities are higher than those on the longer-dated securities.
The two most followed pairs on the yield curve are 3-month and 10-year yields as well as 2-year and 10-year yields. As the above graph shows, the yields on the 3-month bills are about 30 basis points higher than those of the 10-year notes. Historically, an inversion in the yield curve has sparked fears of an impending recession.
Banks typically borrow for the short term and lend for the long terms, resulting in “maturity transformation.” Typically, banks write longer-term loans, which are funded in large part by short-term deposits. As a result, banks benefit from a steeper yield curve.
If the yield curve is steep, banks can lend on the higher long-term rates while borrowing on the lower short-term rates, boosting margins for these banks.
State of the economy
The banking sector benefits from a growing economy. The state of the economy can be measured through GDP growth, unemployment levels, and consumer spending. If the unemployment levels are low, consumers have more disposable income. Increased spending benefits banks through fees earned on credit and debit card transactions.
Moreover, declining unemployment levels mean businesses are employing a larger workforce, indicating increased business activity. This also benefits banks, which can expect a surge in commercial loans and higher fee income from market-related services. As the above graph shows, the unemployment rate in the US has trended downward in the last decade.
Higher consumer spending is also associated with higher credit card and other consumer loans, which benefits banks. Sound economic growth results in increased capital market activities. These activities translate into higher fee-based income for banks for services like underwriting, mergers and acquisitions, and advisory services. According to Lexology, the total US mergers and acquisitions deal value rose 9% year-over-year in the first half of 2019.
Broadly, the US economy has grown consistently in the last decade, which has contributed significantly to the banking sector’s growth during this period.
In the final part of this series, we’ll discuss the latest trends in technology that are impacting banks and the S&P 500 banks.
For another installment of Market Realist’s sector overviews, please read Global Smartphone Companies: An Overview.