The obvious place to start when discussing the impact of Wednesday’s FOMC meeting on US banks is with the downward pressure on net interest margins that will result from the extended period of low rates.
A short, helpful note from Nomura’s Brian Foran breaks down the issue into various components, and we’ll present each in order.
– Consensus expectations for the future path of NIMs had already fallen sharply since September, and clearly a longer expected period of low rates won’t help. Foran nevertheless writes that the asset sensitivity of banks — the extent to which income from asset holdings is sensitive to fluctuating interest rates — won’t be as big an issue as it was last year, when the Fed first introduced its mid-2013 language:
When the Fed said lower for longer back in August 2011, asset sensitive banks got hit hard. This time around they took it in stride. Part of the issue is the surprise factor is gone. As shown in Figure 6 on the next page, the forward path to consensus NIMs is much lower than it was, although there is still a little bit of a bounce in some models in 2013 which is now unlikely. …
The report notes that the asset sensitivity differs at the large banks depending on the asset mix, with Bank of America getting hit the most among the big banks. Click to enlarge this chart that ranks the banks by asset sensitivity:
– And as the securities holdings of banks roll off, the replacements will yield less, also pressuring margins as interest income declines.
As you can see in this chart, Wells Fargo is most exposed to this source of income, as its securities are both relatively high-yielding and account for a high percentage the bank’s income (click to enlarge):
….
– On the plus side, expect banks to deploy more cash. They already started doing this in the fourth quarter — mostly by extending more loans and in some cases buying up more securities (filling some of the gap left behind by European banks, maybe?). Click to enlarge:
– Two more possible offsets to the problems created by lower rates, emphasis ours:
Second, deposit books have largely re-priced, but long term debt is about half of banks interest expense. Banks will look to lower funding costs, in many cases by letting longterm debt roll off…
Third, eventually the mortgage refi tailwind will go away. That said, with rates lower for longer another refi boom is possible in 2012. Plus gain on sale spreads look strong in January so far…
We’re definitely not holding our breath on the refi boom, but who knows. The note goes on to say that those banks with minimal putback exposure should be able to capitalise on any growth in mortgage originations. We’ve chucked the whole note in the usual place if you want further detail.
Our general impression of the note is simply that big improvement in margins will probably have to wait until rates rise as a result of much stronger economic growth than we’re seeing now. The stronger loan growth in the Q4 bank earnings seems to be a hopeful sign, but we’re not ready to say that it’s a sustainable trend. Some of this will also depend on changes to the slope of the yield curve that can’t be anticipated, espcially given the possibility of further QE.
Something the note doesn’t cover, but which we wrote about yesterday, is the potential for Treasury repo rates to rise much faster than unsecured lending rates in the coming years once the Fed does start trying to tighten. The money market fund industry, whose business model has already been struggling with low rates, is also likely to keep shrinking as it attracts new regulatory attention as well — further removing another source of short-term funding for banks. The combination of these two things would suggest that some funding costs will also rise quickly along with rates, meaning the pressure on margins won’t ease as quickly as banks hope.
But we don’t expect that to happen for a while and a lot can change between now and then; just a couple of things to watch.
Related links:
European bank deleveraging and US loans – FT Alphaville
The ‘QE-exit’ inflation paradox – FT Alphaville