Bank stocks have to reckon with the downside of higher rates

Higher interest rates have many benefits for lenders, as the interest income they earn typically rises faster than what they pay for funding. The last time the Federal Reserve started raising rates at the end of 2015, bank stocks sharply outperformed the S&P 500 over the next two years. Now at the beginning of what many believe will be an even more aggressive rate cycle, bank shares are limping, falling nearly 12% so far in 2022. Russia’s invasion of Ukraine did threaten disruptive volatility or credit losses, but resilient earnings so far haven’t yet relieved bank shares.

Instead, earnings have highlighted a key difference from the prior cycle: Banks are much more heavily invested in securities that will decline in value as rates rise, like U.S. Treasurys. Treasurys as a percentage of U.S. commercial bank assets are around 8%—almost double the share at the end of 2015, according to Federal Reserve data. Mortgage-backed securities are at nearly 15% versus under 12% in 2015.

As deposits surged during the pandemic, many banks shifted some cash earning virtually nothing on deposit at the Fed into securities. This was welcome relief for net interest income when these earnings were under so much pressure, and was one factor powering a 35% rally in the KBW Nasdaq Bank Index last year—but now some of the downsides of those moves are coming into view.

The declines in on-paper value of banks’ available-for-sale holdings aren’t reflected in net income, but in accumulated other comprehensive income, or AOCI. Under current banking regulations, AOCI can then flow through to banks’ capital calculations. When rates were plunging, many banks got a vital bump to capital levels as bond values rose. Now that rates are rising, AOCI is a drag. Banks including Citigroup, JPMorgan Chase, State Street and Wells Fargo called out the negative effect of AOCI on key capital ratios.

In other contexts, moves in capital measures might be just a footnote. But a surge of deposits in recent years has bloated banks’ balance sheets, already straining their capital constraints. So these seemingly arcane things can matter to shareholders. As banks run closer to their minimum capital requirements, one thing many may do is slow their return of capital to shareholders in the form of buybacks. Plus, big banks that have reported earnings so far, tracked by Autonomous Research, had an average 5% decline in tangible book value from the fourth quarter to the first quarter.

This isn’t a permanent effect. Bonds eventually mature, and bond prices can also start rising again. Plus, banks often buy shorter-term securities, so they aren’t stuck with low-yielding paper forever, and can then reinvest at higher yields. Another offset is banks adding capital through rising earnings via higher net interest income. Volatility in rates has also been good for Wall Street trading desks. On balance, the math of higher rates can still be positive.

“Rising rates are still a good thing overall for banks, but they are not just good for everything,” says Autonomous analyst Brian Foran.

But investors might be worried about a few other things, too. For one, signals of even more Fed hikes than currently expected or faster quantitative tightening might not deliver as much marginal benefit to net interest income, but could lead to another selloff of bonds. Also, there is the dreaded scenario in which rates are rising but consumers and businesses are struggling, and either not borrowing as much or borrowing more but also defaulting a lot more often.

There may still be more good times ahead for bank stocks if the economy and path for monetary policy remain steady. For now, though, bank investors will have to endure some of the side effects.

This story has been published from a wire agency feed without modifications to the text