The impact of interest rate changes on banks depends on each bank's balance sheet structure and its ability to solve evolving asset/liability situations. The likelihood is that interest rates are going to continue rising in the near term because inflationary fears will force the Federal Reserve to exercise a tighter and more consistent monetary discipline. If the Fed doesn't apply such discipline now, it will be faced with the need to jam on the brakes in the future, causing a possibly wrenching rate spike.

Received wisdom tells us that inflation fears always stir up interest rates and harm bank performance. Supposedly, rising rates increase banks' cost of money and crunch earnings.

But if you believe the stock market, banks are going to do well this year and next. Although rates have been rising since February, stock returns of major regional banks outperformed the market by more than 9% during the year's first half. These banks' stocks were up 4.8% for the year, while the Standard & Poor's 500 stock index fell 4.8%. Money-center bank returns advanced 2.5%, bettering the market by more than 7%.

In part, bank stock returns were driven by investors' expectations of a big payoff from ongoing industry consolidation. And their expectations are magnified by pending legislation that will authorize national interstate branching. In addition, however, investors have been pleasantly surprised by unexpectedly strong bank earnings. First-quarter income topped $11 billion--slightly ahead of 1993's pace--contrary to investors' usual expectation that rising interest rates create a drag on earnings.

Rates did rise, of course, but banking spreads remained favorable because banks' prime lending rates stayed ahead of the surge in short-term rates. Loan growth was very robust in parts of the nation, and banks were savvy about controlling their cost of funds with "sticky" pricing--lagging their deposit rates behind the general upward movement of market interest rates.

Interest Rates and Bank Stocks

The nexus between interest rates and bank stock values is based on two uncertainties. The first uncertainty is how interest rate dynamics will affect bank earnings and investment values. The second uncertainty is the future course of interest rates themselves.

To assess the first uncertainty--the earnings and value effects of interest rate changes--you have to envision banks in terms of two balance sheets separated along the dimension of time. One balance sheet is historic and is the result of past funding and investing decisions. The other balance sheet is contemporary and is, even now, in the process of being formed by current decisions.

The historic balance sheets of most of today's banks were formed during the 1991-93 period of weak loan demand, low interest rates and a sharply sloped yield curve. In this environment, banks booked high-quality assets and, for now, are protected against a new onslaught of loan losses. However, banks also acquired non-liquid investment portfolios heavily weighted by securities with years-to-maturity in the middle-to-high single digits.

Unquestionably, such portfolios are seriously impacted by rising interest rates and the flattening of the yield curve. They are locked in at decreasing spreads as their cost of carry continues increasing. Many banks' portfolios include AFS (available for sale) securities whose losses are passed through the banks' capital accounts and, therefore, impair the banks' capital adequacy.

Contemporary bank balance sheets, on the other hand, have a much different look. These balance sheets are being fueled with resurgent loan demand that coincides with rising interest rates and economic expansion. The new loans, funded with cheap bank deposits, will be a source of near-term earnings strength.

Historically, however, banks have lacked lending restraint during periods of economic growth. Banks' bad debts are notoriously cyclical and often consume earnings in the recessions that follow periods of high loan demand. For now, it is unclear whether banks are lending more cautiously and pricing their loans more realistically than they have in the past. The next recession will tell.

The combined structure of their historic and contemporary balance sheets determines banks' interest rate risk. Recent research by Goldman, Sachs and Co. claims that banks' interest rate risk is far better controlled than it was in the 1980s. The reason? Banks have become more highly skilled in asset/liability management.

Different Effects

Inflation affects both short-term and long-term interest rates. It raises long-term interest rates because bond investors require compensation in the form of a higher rate of return; they expect to be paid back in deflated dollars. Loose monetary policy leaves an excess amount of money around that must eventually push up inflation. When the Fed tightens supply to fight inflation, short-term rates are especially affected.

Inflation has been remarkably low for several years. It could be on the rise, however, because of loose monetary policy. An unmistakable sign of such a policy is the weakening of the dollar on international currency markets. A weak dollar makes imports expensive and adds to inflationary pressures. Above all, a weak dollar reflects soft monetary conditions and slack demand for holding dollars. Inevitably, the Federal Reserve must shore up the dollar by cutting back the rate of dollar creation in order to raise U.S. interest rates and attract more investors to dollar assets.

Popular economics blames the weak dollar on the trade deficit. But the trade deficit is a problem only if it exceeds the amount of dollars foreign private investors are willing to hold. The difference must be made up by official financing through the world's central banks--for example, the urgent purchases of dollars early this summer by the Fed and foreign central banks.

The central bank intervention occurred because of a shortfall in private investment inflows. The reason for the shortfall was clear: foreign investors judged U.S. interest rates to be too low in relation to an inherently inflation-prone U.S. economy. Why should investors conclude that the economy is inherently inflationary? For one thing, a chronically slow rate of investment raises doubts about America's longer-term productivity.

Similarly, the lack of meaningful progress on reducing the trade and fiscal deficits speaks ill of America's economic policies and will. Perhaps most important, monetary policy is too loose, which suggests that inflation will accelerate.

The outlook for interest rates and the effect on bank earnings and stock values are two different issues. World markets are telling us that money is soft and that American interest rates should continue to rise. The effect of rising rates on banks depends on banks' lending postures and their professionalism in asset/liability management.

If monetary policy remains loose, economic growth will be artificially stronger for a while, encouraging banks to generate new loans at a rate that may inflate bad debt writeoffs in the next recession. Also, loose money will eventually force a sharp correction in interest rates, driving investment portfolios that were booked in 1991-93 deeply under water.

For now, monetary restraint and a mild boost in rates is much preferred to a loose policy followed eventually by an unhealthy interest rate spike. The result should be higher and less volatile values for bank stocks.

Donald G. Simonson holds the New Mexico Banker's Chair in Banking and Finance at the University of New Mexico.

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