Bank Stocks Fell. Aren’t Higher Rates Supposed to Help?

If higher interest rates automatically made banks richer, analyzing a bank stock would take about eight seconds. You could spend the rest of the afternoon finding your online banking password.

Tuesday offered a less convenient version. JPMorgan Chase was down about 4% during morning trading on September 22, according to MarketWatch. Barron’s also reported broad banking weakness, with Goldman Sachs and JPMorgan weighing on the Dow. Those were intraday readings.

The decline followed the Federal Reserve’s September 16 decision to raise its target range a quarter point to 3.75%–4%. That creates an understandable question for anyone who bought bank shares expecting them to benefit from higher rates.

The answer starts with an expense that gets surprisingly little attention in the eight-second version: banks have to pay for money, too.

Your savings account is somebody else’s expense

A bank earns interest on loans and securities, then pays interest on deposits and other funding. The difference, net interest income, helps cover everything else, including staff, technology and credit losses.

Higher rates can improve that income when assets reprice faster than funding costs. They can also squeeze it. As the OCC’s interest-rate-risk handbook explains, the timing of changes on each side of the balance sheet matters.

Depositors can shop around. A customer who moves cash from a low-paying account into a higher-paying CD has made a perfectly sensible decision that happens to make the bank’s funding more expensive.

The bank would prefer you forgot to shop around. Your investment thesis shouldn’t depend on everyone being that cooperative.

Some banks have a dependable base of inexpensive deposits. Others need to offer more to attract or retain customers. Their loan books also reset at different speeds, so the same Fed decision can produce very different earnings outcomes.

Higher rates, smaller spread

Consider a deliberately simplified example. A fictional bank has $100 million in loans earning 6%, funded by $100 million in deposits costing 2%. That produces $6 million in annual interest income and $2 million in interest expense, leaving $4 million before other costs.

Now suppose its average loan yield rises to 6.5%, while deposit costs reach 3%. Interest income climbs to $6.5 million, but interest expense reaches $3 million. The amount left falls to $3.5 million.

Rates went up. Net interest income fell 12.5%.

The example leaves out capital, securities, fees, hedging and changes in balances to isolate the arithmetic. It isn’t a forecast for either bank mentioned above. It does show why “they can charge borrowers more” gets you only halfway through the calculation.

For a real bank, I’d check both net interest income in dollars and net interest margin, which expresses that income relative to average earning assets. Loan growth can lift the dollar figure even while the margin narrows.

The borrowers get a vote

More expensive credit can discourage households from buying homes and businesses from financing expansion. That’s intentional. The Fed describes slower spending and demand as part of how monetary policy brings inflation down.

We looked at the pressure on homebuilding in our Lennar earnings piece. Banks face the other side of those financing decisions: fewer attractive loans to make, and potentially more strain on borrowers whose payments reset higher.

Higher loan yields won’t help much if more borrowers fall behind on their payments.

That’s why credit quality belongs in this discussion. Delinquencies show loans falling behind. Net charge-offs measure loans written off, less recoveries. Provisions are expenses reflecting expected credit losses, so they can rise before those losses are realized.

These are risks to investigate in the results. Today’s share-price declines alone don’t establish that any particular bank’s borrowers have deteriorated.

Read three things before deciding the market got it wrong

I’d start with the latest earnings release for a bank you own and make a short note covering three areas: its net interest income outlook, its deposit costs, and its credit-loss trends. Compare each with the previous quarter, using the same definitions.

Read management’s explanation beside the numbers. If interest income is growing, how much comes from more lending? If deposit costs are rising, are customers moving into better-paying accounts? If provisions increased, does management cite loan growth, a weaker outlook or specific troubled borrowers?

You can do this without forecasting the next Fed meeting. Those disclosures help you assess how the bank is handling the rates already in place.

I’d take today’s weakness as a reason to inspect the assumptions behind a holding. A bank’s ability to benefit from higher rates depends on its funding, customers and existing assets. Which of those did you actually examine when you decided higher rates would help?