Think Rising Rates Are Good For Banks? Think Again!
Apr 18, 2022
01:06:46
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Quick takeaways
Rising interest rates may not benefit banks as commonly believed due to potential squeeze on margins.
The Fed's balance sheet reduction and potential selling of mortgage-backed securities pose risks to the banking system.
Banks need to be prepared for disruptions and potential loan losses in the current economic climate.
Deep dives
Outlook for Banks' Growth and Balance Sheets
The banking sector is not expected to experience significant growth due to a projected modest increase in the US economy. Banks will need to shrink their balance sheets by 10 to 15% to improve returns. The key driver for bank valuations is credit, and the recent normalization of credit expenses will impact banks' revenues and earnings.
Impact of Quantitative Easing and the Fed's Balance Sheet
The Fed's quantitative easing policies and low interest rates resulted in boosts to banks' revenues and valuations. However, with credit expenses returning, banks will face challenges in maintaining profitability and earnings. The Fed's balance sheet reduction and potential selling of mortgage-backed securities pose risks to the banking system, as there may not be sufficient demand for these securities.
Risks in Non-Bank Lending and Financial Markets
Non-bank lenders, particularly those utilizing automated underwriting for consumer loans, may face challenges as credit risk increases in the absence of extraordinary support. The housing market, which witnessed strong demand during low interest rate periods, is now becoming a headwind as volumes decrease. There are concerns about risks in the credit card business, but it remains a profitable asset class for banks. Overall, uncertainty and confusion in financial markets present both challenges and opportunities for investors.
The Impact of Rising Interest Rates on Banks
Rising interest rates may not be as beneficial as commonly believed for banks. While higher rates can increase loan yields, it also leads to higher funding costs, potentially squeezing banks' margins. The spread between the cost of funds and loan earnings, known as net interest margin, may narrow as funding costs rise faster than loan earnings. Additionally, banks' ability to secure funds and grow their loan books depends on core deposits and corporate deposits, rather than short-term reserves created during quantitative easing. As rates normalize, banks may face challenges in managing liquidity and ensuring their profitability.
Risks and Opportunities in the Banking Sector
The banking sector faces various risks and opportunities in the current economic climate. With the possibility of a recession, lingering effects of COVID-19, and geopolitical tensions impacting the global economy, banks need to be prepared for disruptions and potential loan losses. European banks, in particular, may be vulnerable due to their involvement in global trade and commodity markets. On the other hand, well-capitalized US banks with excess liquidity are in a stronger position. Investors can find value in the banking market, especially in quality names, but they need to approach it with patience and discipline, considering the potential impact of rising rates and market volatility.
An oft-cited fact is that rising rates support the profitability of the commercial banking system. Chris Whalen, veteran banker, chairman of Whalen Global Advisors & Author of The Institutional Risk Analyst begs to differ. Whalen explains to Farley that banks make money by the spread between their yield on their loans and their cost of funds, and that while rising rates do increase loan yields, they also increase banks’ cost of funds. Whalen also explains why he thinks the Federal Reserve will be unable to do Quantitative Tightening because it will be stuck with mortgage-backed securities (MBS) for many years.
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BCB is Europe’s leading provider of business accounts and trading services for the digital asset economy. With a dedicated focus on institutional payment services, BCB Group provides business banking, cryptocurrency and foreign exchange market liquidity for some of the world’s largest crypto-engaged financial institutions.
For more information, please visit https://bcbgroup.com/jack
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Timestamps:
(00:00) Introduction
(12:35) Inflation
(18:13) The Problem The Fed Faces with Mortgage-Backed Securities (MBS)
(21:08) Can the Federal Reserve Become Insolvent?
(24:57) Mortgage Lending At Commercial Banks27
(27:32) BCB Ad
(28:20) Are Rising Rates Good For Banks?
(31:54) Why A Recession Is Likely?
(34:51) Outlook on Bank Stocks and U.S. Treasuries
(44:00) Biggest Risk: Non-Bank Lenders
(48:31) Credit Card Lending
(51:16) Will Banks Suffer Losses from Russia's Invasion of Ukraine?
(54:40) European Banks
(58:35) Jack's Post-Conversation Explanation
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