Half a decade is a long time to spend in a comfort zone. Quantitative easing by the Federal Reserve has helped the US economy to get back on its feet. It has also provided a measure of certainty to the banking sector as it underwent its own painful restructuring. But as the last Federal Reserve asset purchases (originally begun early in 2009) draw to a close, that is about to end.
QE was a mixed blessing for banks. Maintaining ultra-low interest rates allowed them to borrow cheaply and invest in higher yielding longer term assets. The Fed’s regular purchases also drove up the value of bond portfolios. But low rates also pushed net interest margins to record lows. Overall NIMs – the spread between interest income generated by loans and interest paid on deposits – for US banks were 3.1 per cent in the second quarter, compared to nearly 5 per cent two decades ago.
In theory then, the end of QE and higher rates that result should boost banks’ NIMs. Bank of America and JPMorgan would benefit the most as they are seen as “asset-sensitive” banks – that is, assets are more sensitive to changes in rates than liabilities. A 100 basis point increase in rates would make net interest income at BofA and JPMorgan jump 8 per cent and 5 per cent respectively, according to analysts’ estimates.
But the reality is unlikely to be so straightforward. According to Oppenheimer research, the correlation between rate levels and banks’ margins is patchy. An analysis of data since the late 1980s shows that although most banks are sensitive to short-term changes in rates, economic fundamentals such as demand for new loans and gross domestic product growth also affect the way rate changes affect bank earnings.
Rising interest rates beyond the end of QE will also have broader consequences for balance sheets. One of these is lower bond prices. That would hurt banks holding large trading books such as Goldman Sachs, Citigroup, JPMorgan, Bank of America and Morgan Stanley. The flip side of this is that, for those banks that have stuck by their fixed income trading businesses, greater volatility in the bond markets should boost revenues. That has already been evident in recent quarters.
Leaving QE behind is not then an unmitigated disaster for the banks. But life may soon be getting a little more uncomfortable.
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