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When Rates Rise

Interest rate rise: Redemption at last for banks?

Tighter monetary policy is supposed to boost lenders, but does it?
SEPTEMBER 13, 2015 11:40 PM

by: Oliver Ralph and Laura Noonan

Whisper it quietly especially if you are in the company of politicians or regulators but
banks are finally starting to find life a little easier. The pace of regulatory change is easing,
the worst of the misconduct fines seems to be out of the way and US and UK interest rate
rises are likely to be coming sooner rather than later.
Received wisdom in the banking sector is that higher rates are great news. US banks, with
their heavy domestic focus, can push a Federal Reserve rate rise (http://next.ft.com/conten
t/383eaf3c-52ff-11e5-8642-453585f2cfcd) on to many of their borrowers pretty quickly.
They can also try to delay passing the benefit on to savers for as long as possible. Foreign
banks with US operations get the same benefit, but on a smaller portion of their business.
The big benefit for them is the rise in yields from US Treasury bills and other American
debt. Almost all global banks hold a lot of US debt, since it is highly liquid.
The scenarios are being explored because the Fed is set to raise its record-low interest
rates for the first time in a decade, perhaps as early as this week.
The banks could use a boost. According to the Federal Reserve Bank of St Louis, US
banks net interest margin (the gap between what they pay for funding and what they
charge to lend) peaked at more than 3.8 per cent in 2010 and is now less than 3 per cent.
That is a big chunk of lost profits. In Europe margins are lower still Germanys Deutsche
Bank, for example, had a net interest margin of just 1.4 per cent last year.
Under Basel III regulations, the banks have to disclose some detail about what higher
interest rates would do to their businesses. JPMorgan, for example, says that a 100 basispoint rise in interest rates would add $2.8bn to net interest income (which was $39bn last
year).
And there is a more general way that higher interest rates help. Rising interest rates are a
sign of a strong economy. That will improve corporate profits and encourage companies
to expand. To finance that expansion many of them will look to the banks. Lending
volumes, then, should rise.
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So higher volumes and higher margins. Whats not to like? Potentially, quite a lot. This
happy story has plenty of worrying subplots. Three in particular should be causes for
concern. The first is the impact of rate rises on the dollar. Non-US borrowers have been
enthusiastic borrowers of dollar debt. In emerging markets (http://next.ft.com/content/a43
6ea2a-5187-11e5-8642-453585f2cfcd), for example, dollar-denominated debt has risen 81
per cent to $3.3tn over the past five years, according to the Bank for International
Settlements. Higher US rates mean a strong dollar, making the payments even more
expensive in the borrowers local currencies. Combine that with a slowdown in emerging
markets, and a move by the Fed would make a bad situation worse.
When rates rise (http://next.ft.co
m/ig/sites/when-rates-rise)

The most powerful central bank in

the world is considering whether to
raise its record-low interest rates
for the first time in nearly a decade.
Even before the US Federal
Reserve makes a move, the effects
are reverberating throughout the
global economy. Our project
explores how.
Go to hub page (http://next.ft.com/i
g/sites/when-rates-rise)

The second is the internet. One uncertainty is

what happens to retail deposits, says Bridget
Gandy of Fitch Ratings. There is an
assumption that people dont change their
bank accounts. But because of the new
internet generation we dont know if such
loyalty will still be there. After years of meagre
rewards, savers may jump at the first sign of
an increase to move their money to a more
lucrative account.
The final, less tangible, concern is the popular
attitude towards banks. This time there will be
political pressure to keep loan rates low but
also pressure from depositors, who have been
suffering with low rates, says Sam Theodore
of Scope Ratings. The prospect of banks
making huge profits while the rest of the
economy struggles might be a red rag to the
bank-bashers.

Still, if all else is equal then rising rates should be good news for banks. But all else is not
equal.
1. Steep or flat?
All banks will hope to benefit from better interest margins when rates rise. But some hope
to benefit more than others.
One of the most important drivers of bank earnings is higher interest rates, particularly
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for the US and Asian banks. Higher rates drive higher net interest income and thus affect
bank stock valuations, wrote Morgan Stanley analysts this month.
Much depends on the yield curve, or the
difference between short-term and long-term
rates. Banks, which tend to borrow in shortterm markets and lend in long-term ones, do
well when long-term rates are much higher
than short-term equivalents (or, in the jargon,
when there is a steep yield curve). But rising
rates are often associated with a flatter yield
curve (http://next.ft.com/content/186efcf2-304
5-11e5-91ac-a5e17d9b4cff).
The banks that will do best are those with
more deposits than outstanding loans. The
excess deposits tend to be invested in shortterm bonds at low yields. As soon as short-term rates rise, so do the yields on those bonds.
Chirantan Barua, analyst at Bernstein, points to HSBC as an example of a bank that can
benefit this way. It has $1.4tn of customer deposits and $954bn of customer loans. If it can
start to generate a better return on the difference, profits will jump immediately.
French banks, which tend to pay no interest on current accounts, should also do well when
the European Central Bank pushes its rates up (http://next.ft.com/content/619b139c-3ce411e5-8613-07d16aad2152) though such a move is not imminent. And Italian banks,
which are heavily deposit-funded, are also expected to be beneficiaries of higher rates.
The banks will seek to pass the rise on to borrowers as quickly as possible. But in markets
with lots of fixed-rate loans (northern Europe, for example), it will take longer to do this.
Banks with large credit card operations say it is harder to pass rate rises on to card
customers. And, faced with a rising cost of debt, borrowers with floating rate loans may
move their business elsewhere. Some banks have warned that customer attrition rates
could double when rates rise.
Finally, a number of banks will have to raise the prices they charge corporate borrowers.
Corporate lending is often used by banks as a loss leader for other business. Banks tend
to lend to corporates at a loss or at low margins, says Mr Theodore. That is harder to do
as rates go up as the opportunity cost is higher. Higher prices would mean better returns
on the lending itself, but could dissuade corporate customers from sending other, feehttps://next.ft.com/content/49f8b480525e11e5b029b9d50a74fd14

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earning business the banks way.

2. When bad debts rise
The idea that higher interest rates are a boon
will be familiar to everyone except a banks
borrowers.
For borrowers (except those with fixed deals),
higher rates mean that, sooner or later,
repayments will rise. And given that rates have
been low for a very long time, some borrowers
might find themselves struggling to cope.
The struggle is unlikely to start immediately.
The first few rate rises, which may well be in 25
or 50 basis-point increments, will be a nuisance
for borrowers rather than a reason for worry. But over time the pain grows. Bankers say
that bad debts start to rise 18 to 24 months after rates start to increase.
The pain will not be evenly spread. Customers who have locked in low rates will feel no
change, at least until the fixed rate runs out and the debt has to be refinanced. So in
countries where fixed rates dominate, banks may have a little more protection from loan
losses (albeit at the cost of limiting any increase in net interest margins).
But some customers will be more exposed. A report by Fitch into the consequences of a
US rate rise points to problems in commercial and industrial lending and on the consumer
side. It also points to issues in auto loans and mortgages. Even within these groups, some
customers will be affected more than others. For example, mortgage borrowers with
interest-only loans will be particularly hard hit. Their regular payments will rise by a larger
percentage than those with standard repayment mortgages. In the UK about 3.3m people
have interest-only mortgages, according to the Citizens Advice charity.
There is also potential stress in emerging markets, where higher interest charges could hit
some consumers at the same time as wage inflation slows down. Analysts expect nonperforming loans at Asian banks, for instance, to pick up from historically low levels.
Analysts are already forecasting higher bad loan charges (known as loan loss provisions)
at US banks. At JPMorgan, the annual charge is expected to rise 76 per cent between
2014 and 2017; at Citi by 37 per cent and at Bank of America Merrill Lynch by 143 per cent.
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In June the Bank for International Settlements

canvassed the industry for views about
interest rate risk for banks, focusing on
whether they have enough capital to cover
potential losses.
3. Muted M&A?
Investment banks have been hurt by interest
rates in the past: in 1994 an unexpected rate
rise left Goldman Sachs with losses so big it
had to raise $250m by selling a stake in itself
to a Hawaiian trust. Other investment banks,
traders and investors were hit hard too, as
bond values tumbled when interest rates rose
from a low of 3 per cent in February 1994 to 6
per cent a year later.
Regulators remain concerned about the risks,
but bankers themselves are less so. They say a regulatory crackdown on trading activities
mean they are holding far fewer bonds and derivatives than they were in the past.
Even falls in the value of assets do not always hurt the banks in the way one might
assume. Take, for example, some types of interest rate swaps, which banks own and which
are worth less when interest rates rise. Accounting rules mean banks cannot book capital
or earnings gains on these swaps when interest rates fall and those same accounting
rules mean banks do not have to take a hit to capital or earnings when interest rates rise.
As a result a fall in the value of these swaps will not hurt the banks earnings or capital.
Those rises and falls do not completely disappear though they could hurt banks book
values, or the value of their net assets. This matters because banks are often valued by
shareholders in relation to their book value.
The impact on investment banks revenues is murkier still, with executives admitting that
some income streams will be hit. Companies took advantage of ultra-low rates to refinance
as much as they could in the past two years, so they are unlikely to need to borrow as
much in the near term. M&A, which generates hefty fees, could also become more muted
when companies have to pay more to finance deals with debt.
But other income streams could flourish. Higher rates usually mean more securitisations,
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which could translate in to more fees for the

banks creating them. The transition to higher
rates should also trigger more market volatility
and trading, once again giving investment
banks more revenue.
4. Wage inflation
The impact of rate rises stretches well beyond
banks relationships with their customers. Bank
executives will also have to deal with the
impact on two other groups staff and
investors.
On the staff side, if rising rates are a response
to inflation then those same price rises will
feed through to wage demands. Banks have
been trying to cut costs and, while big bonuses
grab the headlines, banks employ large
numbers of more modestly paid employees.
HSBC and Wells Fargo, for example, each
employ about 266,000 people. With profits still
low, the last thing bank executives need is
wage inflation.
Rising rates also change the outlook for
investors. If higher rates mean larger profits
then a rise in dividends could follow. That said,
income-seeking investors may prefer to spurn
bank shares in favour of fixed interest securities, which by then will be yielding more.
Either way, it is far from clear that rising interest rates are a boon for bank shares. Analysis
from Berenberg suggests that banks on the whole tend to outperform other shares when
rates are falling (rather than rising) and when the yield curve is steepening.
Citi analysts have looked at how bank share prices in various countries have reacted
historically when short-term US rates rise: those in emerging markets (especially Russia
and Brazil) did well; those in developed markets are mixed, with northern European banks
doing well, while UK and US banks do poorly.
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This time may be different. After such a long

period of low rates, any increase will be a
welcome relief for many banks. But with
potential problems in emerging markets,
increased regulatory scrutiny and the threat
around customer loyalty created by the growth
of internet banking, rising interest rates will not
be the one-way bet some banks suggest.
Print a single copy of this article for personal
use. Contact us if you wish to print more to
distribute to others. The Financial Times Ltd.

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