Not Your Father's Bank

In the standard scenario, banks are hurt by rising rates because they have to pay more to depositors and on their own borrowings, while the loans they have already made and bonds they bought are stuck at lower rates. The margin between their cost to get money and their revenue from lending and investing shrinks.

The market appears to be looking back to the last time that the Fed decided to hike rates in a major way -- 1994. In that year, most financial market participants underestimated the Fed's willingness to tighten, and banks got smacked with lower margins and losses on securities and derivatives.

Bank stocks traded up and down wildly in 1994, finishing with a loss of almost 7%, based on the Philadelphia Exchange/KBW Bank Index.

But because the Fed has been signaling its tightening all year, banks are slowly but steadily remaking their balance sheets. "The Fed is allowing banks to adjust to take advantage of higher rates," said John McCune, research director at SNL Securities in Charlottesville, Va. "They wouldn't be able to do that overnight, but over several quarters or a year, they can."

How are they doing it? By selling off or securitizing fixed-rate loans to get them off of their books. At the same time, they are marketing attractive terms on adjustable-rate mortgage loans and pushing floating-rate home equity lines of credit, McCune said.

Commercial loans, which have been moribund for the past few years but should pick up if the economy continues growing, usually have automatic increases built-in if the prime rate goes up. And banks have also been buying mortgage securities whose yields rise when bond market rates go up. Some have been even more creative.

Rate Insensitivity

Wachovia, for example, said it has been preparing for higher rates by convincing brokerage customers to move cash from money market funds to the safety of federally insured deposit accounts. It just so happens that money market yields are highly sensitive to Fed hikes while deposit accounts lag far behind. In fact, Wachovia, which operates in the less-competitive southeastern section of the country, says its depositors are "relatively rate insensitive." In the first half of 2004, the lower yielding accounts had garnered $25 billion switched from money market funds.

As a result of the strategy, the bank said in its recent 10Q filing that its earnings would be 1.8% percent higher if the federal funds rate rose to 3% in a year, up from the 45-year low of 1%, which is where it stood before the Fed started raising rates. If the fed funds rate actually declined over the next year, earnings would be 0.8% lower.

Looking at other banks' filings, Bank America said net income from interest would gain 0.4% with higher rates and fall 0.7% with lower rates. Comerica (CMA Quote) was poised to gain 5% in net interest income on higher rates and lose 4% on lower rates. Bank of New York said it would gain up to 1.5% on higher rates and lose 0.1% on lower rates.

Another key support for the banking industry this time around vs. 1994 is the development of alternative sources of revenue, lumped under the heading "fee income," and encompassing everything from ATM charges to mutual fund fees.

Back in 1994, banks made almost twice as much from interest income as from fees, $147 billion to $76 billion. But by the first half of this year, the numbers were almost equal, with $125 billion from net interest income and $95 billion from fees, according to the FDIC.

At PNC Financial Services Group (PNC Quote), net interest income slid by $48 million, or 5%, in the first half of 2004 because of lower rates on loans and bonds. But fee income rose by $250 million, or 16%.

Banks are also benefiting as people keep more of their assets in cash instead of stocks after the three-year bear market.

All in all, it's not the banking sector of 1994.

Implications and Assumptions

Of course, some of the majors like Citicorp and J.P. Morgan say they are still set up to lose if rates rise. Compared to their competitors, both banks are more dependent on borrowing in the debt markets for their funding than on deposits. The debt markets are a lot savvier about demanding higher rates than depositors, so the pain of Fed hikes is felt more sharply. Those two stocks also rose last month as Treasury yields fell, which makes more sense, since they're more like banks of yore in terms of interest rate sensitivity.

But if the conventional wisdom is wrong -- and certainly it's not applicable to all financial stocks -- then its adherents may be gleaning the wrong message from the sector. The group's recent strength -- the Bank Index is up almost 7% since early August -- may not be a sign that the Fed won't be tightening as aggressively as previously assumed, but that they will. Nor is the rally in financials necessarily inconsistent with the action in economically sensitive cyclicals, which have also been on the upswing of late.

Banks may benefit both from the higher rates and greater commercial loan demand that a growing economy would bring.