Opinion

Rising rates: This phase favors consumers over banks

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It is a matter of faith among many economists and investors that rising interest rates are good for banks and other financial institutions. Historically, rising interest rates have enabled banks to earn more on their investments and increase the pricing or "spread" over funding costs on loans. Bigger spreads generate increased net interest margin or "NIM." But this time around in the banking industry, like much else, things are a little different.

Following the 2008 financial crisis, the Federal Open Market Committee forced down short-term interest rates. This was done in order to provide liquidity to the financial markets and also to maintain the net interest income for the banking industry. From $97 billion in 4Q 2007, the FOMC pushed down the cost of funds for the entire banking industry some 90% to just $11.5 billion in 4Q 2014.

Because bank earnings declined more slowly than the cost of funds after 2007, the industry benefited dramatically. The decline in interest expense for the U.S. banking industry helped to maintain net interest income for banks and their shareholders, but at the expense of savers and investors. By 2014, for example, some 90% of the interest earnings of the U.S. banking industry were going to the shareholders of banks while just 10% was paid to depositors and investors in bank debt instruments. In the 1980s, most of bank income generated from lending and investing went to depositors and bondholders.

Now, however, the proverbial worm is turning in favor of depositors and bondholders. Whereas in 2014 just 10% of bank interest earnings was being paid out in interest expense, now the cost of funds for U.S. banks is rising and rapidly and the portion going to depositors and creditors has doubled. Between the end of 2017 and the end of 2018, for example, total interest income for all FDIC insured banks rose by 17%, but the cost of funds for the industry rose by almost 74%. The rate of change in funding costs is highest among the largest banks, while smaller institutions have tended to see smaller increases in interest expense. The table below shows the cost of funds for the five largest banks and Peer Group 1, which includes the 118 largest banks in the U.S.

So why are bank funding costs rising so quickly? Part of the issue is structural. By pushing short-term interest rates down so far for so long, the FOMC essentially created a temporary subsidy for the banks that is now dissipating. The "gift" from the FOMC, added to $10 billion per quarter from interest paid on excess reserves or IOER, amounted to tens of billions of dollars each quarter diverted from depositors and bondholders to bank equity holders. Now as that balance is swinging back towards a more even distribution between creditors and equity, the cost of funds for banks is necessarily going up.

What is good news for savers and bond investors is not such great news for banks and other leveraged investors. One of the side effects of "quantitative easing" and "operation twist" was to put downward pressure on yields generally, including loans, leases and debt securities. Even as the FOMC has forced up short-term interest rates, duration starved markets have reacted by driving a rally in medium and longer-term securities. Thus the yield on the 10-year Treasury note has fallen almost a point since Thanksgiving. But only if the FOMC relents and cuts short-term rates will lenders feel any relief from rising funding costs.

The continued sellers' market in debt instruments of all descriptions also limits the ability of banks to push up loan rates. Large banks in particular face intense competition for equally big assets due to competition from a wide assortment of also gigantic global funds, central banks and nonbank financial firms. JPM, for example, had a yield on total loans and leases of 5.22% at year-end 2018, before funding costs.

Whereas the quarterly cost of funding for all U.S. commercial banks was just shy of $40 billion at the end of 2018, by the end of 2019 funding costs for the $17 trillion in U.S. bank assets should be closer to $60 billion to $70 billion, with the biggest change felt especially by the larger banks. Asset earnings are rising at one quarter of the rate of funding expenses, BTW, the result of a continued sellers' market in collateralized loan obligations and straight debt. If bank funding costs continue to rise at four times the growth in bank interest earnings, then net interest income for the industry is likely to flatten out and may even decline.

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Interest rates Nonbank CLOs FOMC JPMorgan Chase
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