The Conundrum of a Rising Rate Environment for U.S. Banks

Banks have become quite adept at protecting margins in today's super low rate environment. But with nowhere for interest rates to go but up, are U.S. banks prepared for the inevitable shift higher?

The risks in interest rate spreads
Deposits and loans remain the core business of the modern bank. During times of changing interest rates, loan and deposit rates reset at different intervals -- and deposits generally reset faster. Therefore, as rates rise, the money banks pay to depositors -- their interest expenses -- will increase faster than the money they collect from loans -- their interest income. If this happens, expenses will rise faster than income, squeezing margins until rates stabilize.

Big banks have the advantage
Larger and more sophisticated banks, such as Bank of America (NYSE: BAC  ) , JPMorgan Chase (NYSE: JPM  ) , and Wells Fargo (NYSE: WFC  ) , have an advantage in this process.

Because of their size, these institutions can invest in more derivatives, swaps, or other contracts to mitigate the risks of a rising rate environment. While many smaller institutions do invest in hedges for interest rate risk, the complexity and cost of fully managing that risk can be prohibitive. With their scale, the large banks can devote human and capital resources to units solely focused on hedging risk.

Bank of America, for example, generated $10.9 billion in net interest income (income less interest expense) during the first quarter on a 2.43% net interest margin. JPMorgan yielded $10.9 billion as well with a similar 2.37% margin, while Wells generated $10.7 billion from an impressive 3.48% margin. As rates rise, expect the big banks to maintain this income-producing ability as they all have world-class hedging units tasked to offsetting interest rate risk.

Without the scale of the larger banks, it's more difficult for smaller institutions to allocate human and capital resources to build hedges that mitigate the risks of a changing rate environment.

Source: FDIC Quarterly Q4 2012.

Furthermore, these larger banks tend to offer additional products and services that produce non-interest income. These bolt-on businesses, from corporate treasury services, investment banking, and advisory services for businesses, to insurance, wealth management, and real estate services for consumers, can mitigate a decline in earnings on the loan side of the bank.

Of Bank of America's total revenue, 46% is attributed to net interest income. JPMorgan attributes even less with 43%, while Wells Fargo is more dependent on net interest income with 49% of total revenue coming from loans. For smaller institutions, these ratios tend to skew much higher. The chart below from the FDIC Quarterly Q4 2012 report paints the picture; large institutions generate more than double the non interest income as smaller institutions, even as a percentage of assets.

One certainty
Eventually, interest rates will go up. When they do, it will mean the U.S. economy is most likely in a self-reinforcing recovery; that the employment market is on the mend; and therefore, that consumers are on better financial footing.

It will also mean that the banks will be working to protect net interest margins, a challenging task for any institution. But the big banks -- the Bank of Americas, the JPMorgans, the Wells Fargos -- that are best suited to the task. If you want to invest in this sector, look to the big banks with the sophistication, scale, and diversified incomes to ride out the transition in interest rates better than their smaller competitors.

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