Unlike traditional firms, there is no explicit "revenue" or "sales" line. Instead, there are four major components to examine:
1. Interest income
2. Interest expense
3. Non-interest (or fee) income
4. Provisions for loan losses
Here's an example of how the top of a bank income statement will look:
$1000 Interest income
- $ 500 (less) Interest expense
----------------
$500 Net interest income
- $ 100 (less) Provisions from loan loss
+ $ 500 (add) Non-interest income
----------------
$ 900 Net Revenue
Let's ignore the non-interest income component in our further discussion because this is generally steadier than interest income and interest expense.
Interest income
less Interest expense
----------------
Net interest income
less Provisions from loan loss
----------------
$ X
We can see that banks have a natural hedge built into their business.
Consider the following as a base case for a bank operating in a strong economy:
$1000 Interest income
-$500 Interest expense
----------------
$ 500 Net interest income
-$100 Provisions from loan loss
----------------
$400
Suppose now that the Federal Reserve cuts rates. Because the Fed understands the benefit of maintaining a strong balance system, subtle cues are generally communicated before any cut. In the meantime, the banks reposition their balance sheets so that they're liability sensitive, thus allowing net interest income to widen.
However, if a cut happens, it's for a good reason. A recession might be causing unemployment to rise and bankruptcies to increase. That in turn, leads to higher provisions for loan losses for banks. Here's what might happen in a weak economy:
$1000 Interest income
-$400 Interest expense
----------------
$ 600 Net interest income
-$200 Provisions from loan loss
----------------
$400
Have interest rates impacted the bank? Yes and no. Sure, net interest income widened, but this number is meaningless in isolation. After all, the weak economy caused provisioning to double, thereby wiping out the wider interest spread.
In the real world, this relationship doesn't come out to the perfect round numbers laid out here, but it can be close.
- From 2000 to 2001, for example, FDIC data shows that net interest income grew $16.1 billion for the banking industry, mostly because of lower rates.
- However, the weakening economy caused banks to give most of that benefit back in the form of $13.8 billion of increased provisioning.
Virtually all banks can benefit in this type of scenario. However, big banks also have additional tools at their disposal.
- For starters, the breadth of their business lines makes it easier for them to reposition their balance sheet to focus on one sector versus another, depending on the operating environment.
- Perhaps, most importantly, big banks have the ability to access the capital markets to pass the buck by letting investors purchase the loans (much like a bond) and assume the interest rate risk. Then banks - which still service the loans and collect a fee doing so - can focus on their strengths: credit and liquidity risk management.
At the end of 2002, for example, Bank One owned just $11.6 billion of credit card loans - those it held on its balance sheet - yet it managed a total card portfolio of $74 billion. This has happened industrywide and highlights the strength of larger lenders. For instance, although commercial banks and savings banks held 56% of all US consumer loans on their balance sheets in 1990, that number had fallen to 37% by the end of 2002. Why? Because securitized assets - those that are sold off to investors and that banks continue to service - had risen from 6% of loans outstanding to 35%, according to the Federal Reserve.
Thus, while margins can be impacted by interest rates, large financial institutions are making progress toward managing the interest rate cycle. As you're thinking about interest rate risk, remember that the impact it has on a bank's balance sheet is complex, dynamic, and varies from institution to institution.
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