Why Higher Interest Rates Might Soon Boost Bank Profits

WASHINGTON — Banks appear headed into a new phase of the post-crisis credit cycle where they might actually soon begin to reap some benefits from higher interest rates.

On its face, the Federal Deposit Insurance Corp.'s third-quarter bank earnings report, released Tuesday, showed a still-challenging rate environment. Higher rates continue to lower certain asset values, and mortgage pricing is less attractive, especially for refinancings.

But on the flip side, many institutions are getting greater return on loans they are making as higher rates support net interest margins. For just the second time in nearly two years, quarterly net interest income rose in the third quarter, according to the FDIC.

"It's fair to say higher interest rates have had some positive effects. The steeper yield curve is favorable for net interest margins, because banks generally borrow short and lend long," FDIC Chairman Martin Gruenberg said at the release of the Quarterly Banking Profile.

Overall, quarterly earnings fell 3.9% from a year earlier, to $36 billion, which was the first such drop since the middle of 2009. Lower values on certain fixed-rate assets and weak mortgage demand — both caused by the higher rates — were among the drags on net income.

But digging deeper reveals positive factors. Without a $4 billion spike in litigation costs from a year earlier for one large bank — presumed to be JPMorgan Chase — industry earnings would have posted year-over-year growth. Despite declining mortgage balances, total loans increased — albeit modestly — for the eighth time in 10 quarters. While loss provisions keep declining, sharp reductions in noncurrent loans are aiding reserve coverage.

And even though margins are still low — the third-quarter average margin of 3.26% was 16 basis points below the year-earlier figure — roughly two out of every three institutions have seen margins increase over the last two quarters.

"Average margins rose in the last two quarters at all but the largest institutions, where they declined due to a large increase in balances held at Federal Reserve banks," Gruenberg said. "And while margins remain below year-ago levels, net interest income increased on a consecutive-quarter basis for only the second time in the last seven quarters. The improving environment for margins is especially good for smaller banks, which get a larger share of their revenue from net interest income."

Gruenberg said the higher rates are a "bit of a double-edged sword."

"It's going to be a tricky environment as we transition from a … very low-interest rate environment to a higher-interest rate environment. There are a lot of opportunities for institutions, but risks as well," he said.

Those risks are not insignificant. As rates rise, assets that banks acquired in a lower-rate environment are less valuable. That has begun to affect banks' income statements. In the third quarter, realized gains on securities totaled $540 million, a 60% drop from the previous quarter and an 80% drop from the previous year.

The higher rates have also taken the steam out of refinancings as more expensive pricing leads to lower demand. Overall, 1- to 4-family residential mortgages were down 2.5% from a year earlier to $1.84 trillion. Mortgage originations in the third quarter were 30% below the activity in the second quarter, and mortgage sales declined by 24%.

"This reduced level of mortgage lending led to a $4 billion, year-over-year decline in noninterest income from mortgage activities," Gruenberg said.

Overall, net operating revenue fell 3.6% from a year earlier to $163 billion. Noninterest expenses rose nearly 2% from the third quarter of 2012 to $106.5 billion, driven in significant part by a $4 billion year-over-year increase in litigation expense for a single institution. While the FDIC did not identify the bank, it is likely JPMorgan Chase, which has been entangled in a series of civil cases tied to its mortgage holdings.

Still, net interest income rose 0.7% from the previous quarter to $104.3 billion, even though that was 1.3% less than a year earlier. And balances for all major loan categories besides residential mortgages increased modestly compared to the second quarter of this year.

Total loans rose by 0.9% to $7.8 trillion, the eighth such increase in 10 quarters. Auto loans increased by 3.2% to $346 billion and credit card balances rose by 1% $677 billion. Loans to states and municipalities rose by 7.3%. But home equity lines of credit decreased by 2.1% and balances for other types of residential real estate loans fell by 0.7%. Major mortgage lenders saw their mortgage originations drop sharply, by 30%, compared with the second quarter.

Meanwhile, even though banks continue to set aside smaller provisions to cover future losses — which helps boost earnings — sharp declines in noncurrent loans mean that institutions should have sufficient loss reserves. Banks reduced their loan-loss reserves by 4.3% in the quarter, or $6.5 billion, which is the 14th straight quarter of lower reserves. But with noncurrent loans falling by $18 billion, the so-called "coverage ratio" of reserves to bad credits increased for the fourth straight quarter, from 62.3% to 64.5%.

Gruenberg said the industry is still benefiting from an overall improvement in credit quality.

"Most of the positive trends we have been seeing in industry performance continued in the third quarter," he said. "Fewer institutions reported quarterly losses, lending grew at a modest pace, credit quality continued to improve, more banks came off the 'Problem List,' and fewer banks failed."

Deposits grew by 2.3% — or $247.8 billion — from the previous quarter to $11 trillion. The biggest growth was in accounts with more than $250,000.

The FDIC said banks on the "Problem List" declined by 38 to a total of 515 institutions on the list. The balance of the Deposit Insurance grew by about $3 billion to $40.7 billion. The ratio of insurance reserves to insured deposits grew by 4 basis points to 0.68%.