Higher Rates Aren't So Bad for Banks, After All

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.