If rate hikes are over, what happens to bank earnings?
As the U.S. Federal Reserve (Fed) increased interest rates, banks' net interest margins expanded along with bank earnings. But now that the Fed appears to be done raising interest rates, what happens to banks' profitability? As Lisa Welch, portfolio manager of John Hancock Regional Bank Fund, explains, bank earnings may continue to grow and profitability can remain high due to rising loan volumes.
Banks get the majority of their revenue from the lending business, or net interest income. Net interest income is very steady for the banking industry. In fact, it has only declined on an annual basis five times in the last 84 years. Because net interest income is driven by loan volume and rate, a rising volume with flat rates continues to imply rising income.
Loan growth for the industry is almost always positive and should be a reflection of economic growth. For the next few years, Lisa and her team expect 3% to 5% industry loan growth based on about 2% GDP growth plus 2% inflation.
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Lisa Welch: There have been a lot of questions about interests rates and what will drive bank earnings if the Fed is done raising rates.
Banks get the majority of their revenue from the lending business, or net interest income. Net interest income is very steady for the banking industry. In fact, it has only declined on an annual basis five times in the last 84 years.
It's important to think about what drives net interest income. Net interest income is driven by volume and rate. Volume is the amount of loans that banks have and the rate is the net interest margin, or spread, between what banks earn on their loans and what they pay on their deposits.
Loan growth for the industry is almost always positive and should be a reflection of economic growth. Typically, think of the level of real GDP plus inflation. For the next few years we are expecting three to five percent industry loan growth based on about two percent GDP growth plus two percent inflation.
The net interest margin has increased in recent years as the Fed has moved to normalize interest rates. It was very difficult for banks to operate in the zero interest rate environment that we had coming out of the financial crisis, and banks saw their net interest margins decline as deposit costs were at floors and loan yields kept repricing down.
As the Fed increased rates, banks were able to see an expansion of their net interest margins. The big question is, what happens now that the Fed is done? We believe net interest margins will increase in 2019 over 2018 as there are some lagged benefit from last yearÕs rate hikes. And then net interest margins will likely be flat to slightly down in 2020 given the expected flat interest rate environment.
Despite this scenario, we believe earnings will continue to grow and profitability will remain high for the banks. Banks actively manage interest rate risks and try to neutralize their balance sheets and revenue streams from rate movements. This was almost impossible to do in a zero interest rate environment because the banks did not want to move to negative deposit rates.
So when the Fed began to raise interest rates, there was almost an instant benefit or immediate benefit to banksÕ revenue. Now that the Fed has moved from a zero interest rate policy, banks are now able to neutralize their sensitivity to interest rates. The banks are already starting to take actions such as putting floors in their loan rates or swapping some of their variable loan rates to fixed, to neutralize their interest rate positioning.
We think that the net interest margins will hold up well in this pause period and bank profitability will be more resilient and sustainable compared with the current market expectations.