Why are banks benefiting from rising rates?

Financial services are among the most resilient businesses in the turbulent year 2022. As industry giant JP Morgan pointed out in May, banks are benefiting from a favorable environment due to rising interest rates, and they are not the only ones: insurers and all players involved in credit activities will be able to get their heads above water. And for good reason, the very low refinancing rates of the ECB and the fed, which translate into easier access to debt for companies and households, were a real poison for groups whose business is essentially based on the creation of an intermediation margin.

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The shift in monetary policy

To overcome inflation, the Fed has initiated a shift in its monetary policy. It went from doing whatever it takes to save the economy to doing whatever it takes to curb price increases. To do this, it ended the fourth version of its QE, an unconventional tool that boosts the economy by facilitating government financing (and therefore stimulus plans). The end of quantitative easing is necessary because it is the main cause of inflation, because of a significant increase in the money supply that it generates. It is therefore natural to slow down this mechanism if we want to curb inflation, but this must not put the economy of the region concerned in a perilous situation (this is why there is a gap between the monetary policies of the Fed and the ECB). Beyond the end of QE, the Fed also started a program to raise its key rates, which has intensified compared to the initial plans. In May, a 0.5 point increase took place and markets expect a similar move in June. By the end of December the refinancing rate should approach 2.5%.

A favorable dynamic for lending activities.

The fact is that banks, like insurers and all financial companies, make more profit when interest rates rise. Their margins increase when the spread (i.e. the difference) between the cost of their financing and the remuneration of the credits they grant increases. This dynamic is even more pronounced when rate increases follow one another at regular intervals, over a short period of time. This is because the bank remunerates its depositors on a contractual basis over the year, while it can lend in the very short term at rates that are increasingly high. The real job of a bank is therefore to optimize the mismatch between the maturity of its assets (loans and investments) and the maturity of its liabilities (deposits and borrowings) according to the economic context.

Let's imagine that a bank pays 2% interest on its deposits per year and that three rate increases of +0.3% are to come before December. Over the year, the bank's cost of financing remains at 2%, but it lends successively in the very short term (for example, three months) at 2.3%, 2.6% and then 2.9% as rates rise successively. The spread therefore improves each time and boosts the bank's margins until the arbitrage opportunity disappears when the deposit rate is reset the following year. The situation is much the same with short-term financing from central banks: in periods of economic expansion, the refinancing rate evolves less quickly than the interest rate on loans. This is because there is a strong demand for loans from economic actors who wish to invest in order to meet the increase in activity. The supply/demand ratio is therefore tilted more in favor of demand and the price of loans increases. A systemic commercial bank is particularly well placed to take advantage of this arbitrage opportunity and increase its net interest margin.

A context that remains quite particular

Beware, however: today, when a bank needs short-term liquidity, it finances itself mainly on the interbank market. On this market, money is exchanged at rates that also reflect monetary policy expectations. Sometimes, short interbank rates can move faster than long rates and distort the yield curve (as is the case in the United States). This reflects the fact that few players are willing to lend for the long term because they believe that the risk is high. Under these conditions, it is more difficult for a bank to make money.

Also, it is clear that monetary policy over the last 15 years has created a major distortion of these dynamics because the supply of credit has been made almost free and unlimited by QE to stimulate the economy and investment. The supply/demand ratio is therefore clearly tilted in favor of supply, the interest rate on loans is falling, the bank's spread is falling and so is its interest margin.

The outlook

In the current context, two scenarios are emerging in the long term. The Japanese scenario with lasting stagflation and interest rates that, despite future increases, will remain very low. These conditions will encourage banks to take more risks in order to obtain a spread worthy of the name. The other scenario, more optimistic for banking stocks, is that of the normalization of monetary policy with a gradual increase in rates towards the historical average (average in the US over two centuries: between 5% and 6%). European banks would then be major investment opportunities (as there is no tightening of monetary policy in the eurozone yet, unlike in the US where the movement has already begun). Banks could also reduce the provisions booked for bad debts which destroy their results when the economic outlook is bad.