The bank earnings hit Wall Street recently, and the effects of higher interest rates rippled across the sector. To avoid talking about every single company, here’s a rough guide to understand why the earnings were affected the way they were.
Higher Interest Income
Net Interest Income (NII) rose at banks across the board this quarter, with 13% and 8% gains for JPM and BofA, respectively. The Fed’s hike raised the Effective Federal Funds Rate (EFFR) and the Secured Overnight Financing Rate (SOFR). These two are the basis for consumer and corporate loans. As they’ve risen, so have the interest payments on new loans and floating-rate debt.
Deposit costs were another worry. Due to greater default risk, banks tend to lend less and hold more in reserves. We saw this play out with Wells Fargo this quarter.
Bond Valuations and Book Value
This is another key piece in the results. Increasing rates erode the value of older bonds over time, causing them to decrease in value. Paper losses on BofA’s portfolio passed $100B. Unrealized losses on total debt securities rose to $109B. These paper losses make their way into Balance Sheet hits under Additional Other Comprehensive Income (AOCI). AOCI losses more than doubled for JPM and Wells Fargo. It’s important to note that these losses translate to AOCI when they are listed as Available-for-Sale (AFS), not Held-to-Maturity.
AOCI decreasing shrinks shareholders’ equity. This makes banks look more expensive on price-to-book multiples. This multiple compression can lead to downward rerates to eliminate the premium depending on how earnings went.
Credit Pressure
Higher rates make borrowing more expensive, so some borrowers struggle to repay. Banks respond by setting aside more money for expected losses, called provisions. They also write off loans that are unlikely to be repaid. This shows up first in the riskiest loans.
The recent earnings showed a split between larger and smaller banks. The biggest banks had credit hold-ups. Citi set aside extra cash, but both Citi and BofA had pretty flat provisions. Smaller banks showed more stress. A few of them lost millions on risky loans.
Asset Valuations
When rates rise, the value of assets that back loans, like buildings and homes, tends to fall. Buyers demand higher returns, and financing costs more. That hurts banks since collateral is worth less and borrowers with falling property values struggle to refinance.
On the pure stock market size, the cost of equity under a company’s cost of capital increases. This increases the required return on equities. Since the risk-free rate affects valuations, equities normally take a hit. Higher borrowing costs normally add to this effect, especially right now as we’re seeing high AI spending.
One Last Note
The recent bank earnings were highly influenced by interest rate movements. Hopefully this article helps with understanding why they turned out the way they did.
Disclaimer:
This blog post is for educational and informational purposes only. It is not financial advice. I am not a licensed financial advisor, and nothing in this post should be interpreted as a recommendation to buy or sell any securities. Trading involves risk, and results are not guaranteed. Past performance is not indicative of future results. Always do your own research and consult with a licensed financial professional before making any investment decisions. None of my statements or points of view are necessarily reflective of the views of Deep Knowledge Investing.
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