Textbooks say that banks make money by raising deposits relatively cheaply from savers and lending them, at a higher rate, to borrowers. The difference between the two rates is known in the trade as the “net interest margin” (NIM), and its size is an important factor in banks’ profits. But as the financial crisis prompted central banks around the world to lower interest rates almost to zero (and below, in a few cases), banks have been in a quandary. They cannot lower deposit rates enough to be able to lend at a decent margin, since most assume that depositors will not tolerate negative rates. Instead, they have watched the NIM shrink (see chart, below), and tried to recoup some of the lost profits by raising fees.

America’s 5,600 banks have therefore eagerly been awaiting the turn in the interest-rate cycle, in the hope that higher rates will bring a wider NIM and thus fatter profits. Since January 28th, when Janet Yellen, the chairman of the Federal Reserve, suggested the first increase was not too far off, bank shares have risen by 11%, much more than the market as a whole. In a presentation in February, JPMorgan Chase, America’s biggest bank by assets, noted that in 2005-10, its net interest margin averaged 2.95%; last year, it was just 2.18%. Raising it by half a percentage point, the bank said, would increase earnings by $10 billion.

economist_banksBy the same token, HSBC, a multinational bank which has a relatively small retail operation in America, predicted that an increase of a percentage point in the currently negligible price banks charge for overnight loans would add $100 million to its net income. “Custodian banks,” such as Bank of New York Mellon and State Street, which have lots of ready money to invest, would also be big beneficiaries.

Why have banks’ share prices risen, in that case? In theory, banks have learned to insulate themselves from the adverse effects of rising rates. Relatively few banks still follow the textbook model, simply taking in deposits and dispensing long-term credit, notes Frederick Cannon of KBW, an investment bank. Instead, they often sell off the loans they originate or use derivatives to hedge against rate hikes. At the same time, many are raising more funds through certificates of deposits and or other fixed-rate, longer-term instruments.

Rising rates, however, have not always been a heartening prospect for banks. It used to be, as in most industries, that when the price of their main input — money — went up, profits fell.

A paper* published in 2014 by three economists at the Federal Reserve Board explains why. Short-term rates are usually lower than long-term ones. Since most deposits are short-term, but many of the loans banks make, in the form of things like mortgages, are long-term, the gap between short and long rates helps to pad the NIM. But as long-term rates rise, so does the discount rate that must be applied to future earnings, depressing the value of long-term assets more than short-term liabilities. Moreover, higher rates crimp economic growth, curbing demand for loans and raising the number of defaults.

Nonetheless, notes Cannon, similar optimism about the impact of the first rate rise after a long period of rock-bottom rates proved misplaced at Japanese banks in 2006. Loan demand remained sluggish, margins narrow, and share prices listless. Even if banks manage to avoid the write-downs on assets that have come with rate rises in the past, they still face another problem: the possibility that the price of attracting deposits rises more quickly than the interest they can charge on loans.

Deposits are normally assumed to be “sticky,” meaning that customers do not bother to move their money around very often in search of higher rates. Changing banks is simply too much hassle. That effect may be diminishing, however, as technology makes it easier to find and exploit better deals. What is more, other banks are not the only entities competing for savings. Money-market mutual funds, which have ceased to provide much competition to banks as the securities they must invest in provide little return, might become fiercer rivals if rates rose.

In short, bankers betting on higher interest rates may be disappointed. When banks borrow short and lend long, they are vulnerable to the revaluations rate rises bring. It would be natural to respond by providing ever less long-term credit. But in doing so, they may also deprive themselves of long-term rewards.

*“Interest Rate Risk and Bank Equity Valuations,” by William B. English, Skander J. Van Den Heuvel and Egon Zakrajsek

© The Economist Newspaper Limited, London (July 11, 2015)

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