By John Carney
Why have bank stocks shot up so fast in the wake of Donald Trump's electoral victory? There are 250 billion reasons.
Over the past six or so years, superlow interest rates, combined with far more stringent regulation, have taken a heavy toll on banks. By one measure, they have potentially cost banks about $250 billion in foregone income.
So rising long-term bond yields and the prospect the era of superlow rates generally is winding down have investors salivating over a windfall. Their euphoric reaction underscores just how painful the low-rate era has been for banks, even if there is still much debate over the Federal Reserve's extraordinarily accommodative policies.
In the earliest days of ultralow rates, banks benefited as their securities portfolios rose in value, loan defaults declined and funding costs dropped. Indeed, policy makers viewed low-rate policies as supporting banks and the broader economy.
Yet those benefits faded as loans refinanced at lower rates and one-time boosts to bond and loan portfolios ran their course. Over time, gains dissipated and lower rates remained, squeezing bank profit margins.
"I think the problem here is that the low-rates policy has been so prolonged," said Richard Fisher, a so-called monetary-policy hawk who as president of the Federal Reserve Bank of Dallas until last year sometimes favored a less accommodative policy.
Supporters of ultralow rates note costs to banks would be worse if, absent strong Fed action, economic growth was even more anemic than in recent years. And the big fear around superlow rates -- that they would spur rampant inflation -- hasn't materialized.
Fed Chairwoman Janet Yellen defended the Fed's policies in an August speech, saying that studies have shown that these "helped spur growth in demand for goods and services, lower the unemployment rate, and prevent inflation from falling further below our 2 percent objective."
Even so, the longer superlow rates persist, the worse off banks' profits. "Low rates have led to the lowest bank net interest margins in six decades and lowest revenue growth in eight decades," said CLSA banking analyst Mike Mayo.
A bank's net interest margin measures the difference between its interest income and interest expense expressed as a percentage of its average earning assets.
There is no exact way to know how much low rates have cost banks. For a rough idea, look at banks' return on assets, a broad measure of profitability. Between 1996 and 2006, U.S. banks had an average return on assets of 1.23%, according to Federal DepositInsurance Corp. data. Since 2010, the average has been just 0.94%, the data show.
If U.S. banks had earned the precrisis average return, cumulative earnings from 2010 -- when the Fed launched its bond-buying program -- through the fourth quarter of 2015 -- when the Fed raised its interest-rate target for the first time since the financial crisis -- would have been around $1.07 trillion. Actual earnings were around 27%, or around $250 billion, less, according to FDIC data.
Jeff Davis, managing director of Mercer Capital's financial institutions business, said this is "not the scenario investors want, much less contemplated" from the Fed's policies.
The impact on banks of lower-for-longer rates is especially evident in net interest income, the money generated by the difference between the interest a bank receives on its assets and pays on its liabilities. After growing at a steady clip from 1985 to 2010, net interest income at U.S. banks has stagnated -- going to $432 billion at the end of 2015 from $430 billion at the start of 2010, according to FDIC data.
At the same time, total assets at banks in the U.S. rose around 22% to $15.97 trillion.
This growth of assets without growth in interest income is "particularly damning," said Mr. Davis. "The assets require capital. Shareholders provide the capital. A lot of additional capital has been provided in which the return at the margin is minimal."
Adding to the pressure: Regulators have required banks to hold more equity. That, combined with lower returns on assets, has led to far lower returns on equity. Between 1996 and 2006, the return on equity for U.S. banks averaged 13.65%, according to FDIC data. Since 2010, the average has been 8.40%.
The Fed's policies have been doubly painful because near-zero rates suppress the short end of the yield curve, while its bond buying has pulled down longer rates. The yield curve depicts the difference between short-term and long-term interest rates.
"A lot of the buildup in assets post crisis has been a result of monetary policy which has injected more than $2 trillion of cash assets on bank balance sheets," said Goldman Sachs bank analyst Richard Ramsden. "This has the effect of blowing up bank balance sheets with cash and deposits with minimal to zero net income."
The shape of the yield curve amplifies the impact of superlow rates. Looking at data from 1995 to 2012, researchers from the Bank for International Settlements found banks lose more from very low rates and flat yield curves than they gain from rising rates and steeper curves. "This indicates that the impact of interest rates on bank profitability is particularly large when they are low," the researchers concluded.
This is because banks use deposits with short maturities and low rates of interest to fund loans with longermaturities and higher rates of interest, said New York University Stern School of Business professor Lawrence White. "When the yield curve flattens -- as it has, because interest rates generally are quite low and zero is the lower bound for deposits -- bank profitability generally suffers," he added.
That shows up in banks' net interest margins. At the start of 2010, these averaged 3.84% for U.S. banks. By the second quarter of 2016, they had fallen to 3.08%, FDIC data show.
Write to John Carney at firstname.lastname@example.org
(END) Dow Jones Newswires
November 26, 2016 07:14 ET (12:14 GMT)
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