With expectations rising that the United States Federal Reserve may re-commence its interest rate tightening schedule as early as next month, one potential investment opportunity could be the downtrodden global banking sector. Indeed, it may surprise some investors to know that rising short-term interest rates can in fact help profitability for some global banks, as it helps fatten net-interest margins (NIMs).

Fed rates hikes back on the table?

In an important speech last Friday, Chair of the United States Federal Reserve, Janet Yellen, suggested the case for raising US interest rates “has strengthened in recent months.”  That should be evident from the fact that growth in US employment and consumer spending has remained fairly robust of late, and downside global risks from the United Kingdom’s “Brexit” decision appear to be diminishing.

Not to be outdone,  the Fed’s vice-chair, Stanley Fischer, indicated in a follow up interview that the Fed had not ruled out raising rates as early as its next meeting (September 20 to 21) should the run of US economic data over coming weeks remain fairly solid.  Most in the spotlight is this Friday’s US payrolls report.  If the report reveals another strong gain in employment of around 200,000 or more (market expectations are for a 180,000 gain), the case for a near-term US interest rate hike would likely intensify.

Higher rates can help bank profitability

Against this, however, it’s also the case that some elements of bank profitability can benefit when rates rise. NIMs, for example, may rise to the extent that banks are better able to raise lending rates while rates on some liabilities – such as at-call deposits – tend to remain relatively sticky.  Indeed, recent research from staff at the US Federal Reserve* found that the decline in short-term interest rates across advanced economies in recent years has acted to squeeze global bank NIMs,  “as banks are reluctant to lower deposit rates, especially below zero.”

What’s more, the decline in long-term interest rates – through active central bank bond buying programs – has also squeezed bank NIMs by flattening the yield curve, which has crimped the ability of banks to make money through their traditional maturity transformation role of borrowing short-term and lending long-term.  The impact of a decline in interest rates becomes especially severe as interest rates approach the zero lower bound.

Drawing on evidence across 3,418 banks from 47 countries covering the period from 2005-2013, the authors examined the level of NIMs and return on equity (ROE) in both low and high interest rate environments – periods defined by whether a country’s 3-month sovereign paper was trading above or below a cut-off level of 1.25% p.a.  As evident in the chart below, the research suggests that both NIMs and ROE tended to be higher in higher interest rate environments.

Source: US Federal Reserve.  Orange bars represent high interest-rate environments, and blue bars represent low-interest rate environments.  

It should also be remembered that higher interest rates do not necessarily spell hard times for stocks if rates are rising because underlying economic conditions remains robust and inflation relatively low.  That’s because the rise in rates is likely to be moderate and, due to low inflation, not intended to slow the economy down per se.  This may be especially the case for stocks that were particularly hurt by the previous low interest rate environment and may appear to offer relatively good value.

Global banks – their time to shine?

Source:Bloomberg. Past performance is not an indicator of future performance. 

Global Banks vs MSCI World Index (Local Currency terms)
Price to Book Value Comparison: 31-January 2007 to 29-July 2016