Higher Interest Rates Won't Solve Banks' Problems

Many banks struggling to bolster profits have pinned their hopes on the Federal Reserve's expected interest rate hike later this year. They may want to curb their enthusiasm.

The Fed's postcrisis recovery policy has been to keep interest rates low. Some believe this policy is responsible for current low net interest margins. Thus, many bank analysts and managers believe the rate increases will improve NIM, net income and ultimately stock prices.

In fact, NIMs' long-term structural decline began well before the financial crisis. And while rising rates may temporarily improve NIM and net income, they will not increase bank stock prices for at least three reasons.

First, it is true that a rate hike may initially allow banks to fund new assets at higher rates with current low-priced and non-maturity core demand deposits. But customers are likely to chase rates by liquidating current low cost or non-interest bearing demand deposits in favor of higher-yielding alternatives such as certificates of deposit once rates rise. Technology has reduced the switching costs of moving deposits and thereby made them less sticky. This will alter the size and mix of bank deposit bases leading to possible liquidity risks. Thus, the income benefits of higher rates are likely to be temporary at best as deposits are repriced.

Next, the long period of low rates has increased the lure of interest rate risk by exploiting the term premium normally present in the yield curve to inflate short term earnings. Regulators have noticed that banks have increased their holdings of long-duration, low-rate, fixed-yield assets such as mortgages, especially at smaller institutions. Consequently, they are exposed to capital losses as rates rise and mortgage values fall. These losses will offset at least partially any NIM gains from higher rates. Furthermore, raising rates may actually harm NIM if the yield curve flattens.

Finally, rate increases have a negative valuation effect on stock prices. Shareholders, like depositors, justifiably demand higher returns as rates rise. This higher required return or cost is not reflected in bank financial statements. It is, however, reflected in higher discount rates used by investors to value expected future earnings. The reduced present value of future earnings is reflected in lower stock prices despite NIM increases.

A practical example is provided by your money market investment account. Imagine you have $1,000 invested in such an account earning the current market rate of 3%. If rates increase to 4%, your income jumps by a third. The value of your investment, however, remains unchanged as the increased income is discounted at a higher rate. Unfortunately for bank shareholders, many bank managers will take credit for the income increase and receive a bonus due to poorly designed incentive contracts, while their bank earnings and book multiples remain constrained.

Banks' increased emphasis on changes to benchmark interest rates is understandable. However, it is critical to avoid a simplistic and incomplete analysis of those changes. Offsetting effects complicate any inferences about the overall impact of rate increases. Since higher rates are unlikely to drastically improve their stock prices, banks would be better served by focusing on improving their customer franchises, risk management and efficiency.

J.V. Rizzi is a banking industry consultant and investor.