With the Fed poised to get back into interest rate hiking mode again soon — likely this week — it's a good time to consider what banks tend to benefit the most when rates rise.
If you hate the "big banks" there's bad news here for you. The best banks to buy ahead of this Fed policy shift happen to be Citigroup (C), JPMorgan Chase (JPM) and Bank of America (BAC).
Before we get to the details of why these three may benefit the most, let's take a step back for a quick primer on why banks generally do better as interest rates rise, and how to tell which will do the best.
The answer may seem simple enough: Banks make money by charging interest, so when they can charge more, thanks to the Fed, they earn more. But it's actually a bit more complex than that. After all, banks have to pay interest to get the funds they lend. This means costs go up, too, when interest rates rise. So the key is to go with banks that can boost what they make on loans faster than their cost of money goes up.
In technical terms, you want to go with banks whose "net interest income" (earnings taking into account the higher cost of money) goes up the most as rates rise. This typically means banks whose assets, or loans, re-price faster than their sources of funds, or deposits and borrowing, known as "liabilities."
For example, banks with lots of deposits that customers may be reluctant to switch out of because of the hassle can hold off longer on paying more interest on those deposits. So as the Fed hikes rates, the costs of these funds rise more slowly than the rates the banks earn on loans.
Recent research by Barclays found that JPMorgan, Bank of America and Citigroup have the highest "net interest income sensitivity," along with several regional banks like State Street (STT) and M&T Bank (MTB).
Regional Banks Are More Expensive
The problem with regional banks, says John Hancock Asset Management bank sector analyst
Michael Mattioli, is that they are much pricier. The two regional banks above, for example, trade for 13.4 and 13.7 times 2016 earnings, compared to just 9.1, 10.6 and 10.9 times forward earnings for Citigroup, JPMorgan Chase and Bank of America.
True, the big banks deserve to trade at some kind of discount, says Mattioli. That's because they have higher regulatory risks and costs. They have to keep more capital on hand, for example. They're also not growing as fast as regional banks, which can boost growth rapidly via acquisitions. In contrast, the big banks are barred from such deals because they already control so much of the nation's deposits. Banks can't do buyouts once they hit 10 percent of the country's deposits.
But the big banks are being overly discounted for these drawbacks, says Mattioli. To see how, let's zoom in on price-to-book valuations, in many ways a better tool for measuring banks than price to earnings.
Citigroup and Bank of America trade for a price-to-book ratio of about 0.78, and JPMorgan is at 1.1. That's well below the 1.4 and 1.5 price-to-book ratios for M&T Bank and State Street, and 1.5 for regional banks overall.
This discrepancy doesn't make sense, says Mattioli, since the big three have so much room to boost their profitability as they continue to cut costs, buy back shares and build out higher-margin businesses like wealth management and advising on mergers and acquisitions.
Let's look at JPMorgan, as an example. The bank currently has a return on equity of about 10 percent. But it has the potential to boost that to 13 percent or 14 percent, Mattioli calculates. By his estimates, this means JPMorgan should eventually trade for a price-to-book valuation of 1.4-1.5 times, a 30-plus percent increase from here. You can make a similar case for Citigroup and Bank of America. "They still look cheap relative to their expected return on equity," says Mattioli.
In contrast, regional banks are much more fully priced and they don't have as much room to improve their returns on equity, even with help from the Fed in the form of higher rates.
The big banks themselves have mapped out in their filings just how much better they’ll do as interest rates rise. Let's take a look at what the big three see in store.
Bank of America
In its most recent quarterly filing, Bank of America estimated that a 1 percentage point increase in interest rates — the possible total Fed rate hike over the next year or so — would add $4.5 billion in net interest income, or revenue. That would add 28 cents a share, after tax, to reported earnings — a 20 percent increase over expected 2015 earnings of $1.43 per share, says Mattioli.
This bank says a 1 percentage point increase in interest rates would boost net interest income by 53 cents a share, or about 9 percent of the $5.76 consensus 2015 earnings. Part of the reason for this is that customers tend to stick with JPMorgan — so much so that Morningstar analyst James Sinegal estimates the bank can pay zero interest on about a third of its $1.4 trillion in deposits.
Here, a 1 percentage point increase in rates would boost after-tax net income by about $2.15 billion, for a gain of 47 cents a share. That's about a 9 percent increase over 2015 earnings per share estimates of $5.54. Goldman Sachs banking analyst Richard Ramsden lists Citigroup as a top pick, along with Bank of America, in part because of improved earnings stability.
Who's Left Behind
If Citigroup, JPMorgan Chase and Bank of America are among those who stand to do the best when interest rates go up, who benefits the least? According to Barclays analyst Jason Goldberg, Fifth Third Bancorp (FITB), Huntington Bancshares (HBAN), Northern Trust Corporation (NTRS), U.S. Bancorp (USB) and Wells Fargo (WFC) are the least "asset sensitive." This means their loan books re-price the slowest, compared to deposits, as rates rise.
And Ally Financial (ALLY) stands out as the single bank in Goldberg's coverage universe that actually does worse in a rate hike environment. Its deposits re-price faster than its assets, potentially hurting net interest income as rates rise.
At the time of publication, Michael Brush had no positions in any stocks mentioned in this column. Brush is a Manhattan-based financial writer who publishes the stock newsletter Brush Up on Stocks</a>. Brush has covered business for the New York Times and The Economist group, and he attended Columbia Business School in the Knight-Bagehot program.