The Deal: Banks Poised to Benefit from Higher Rates

NEW YORK ( TheDeal) -- Banks face a brighter outlook against a backdrop of rising rates, yet the impact will vary widely among lenders, analysts warn.

Federal Reserve Chairman Ben Bernanke said Wednesday he foresaw a moderation in the pace of the Fed's asset purchases later this year, eventually ending in mid-2014 when unemployment is likely to be around 7%.

Using the analogy of driving, he likened it to taking pressure off the gas pedal as the economy picked up speed rather than applying brakes by raising official interest rates -- noting 14 of the Fed's 19 board members expected the first rate rise in 2015.

"The fundamentals look a little better to us -- in particular, the housing sector which has been a drag on growth, with the rise in prices creating construction jobs, helping consumer spending and sentiment," Bernanke told reporters at a press conference. "State and local governments no longer have to lay off workers and generally financial conditions are improving."

Bernanke said the main drag on growth was tighter federal fiscal policy and stressed that the Fed's asset purchase plans were tied to economic improvement.

Major bank stocks had mixed performance on Wednesday, a scenario that analysts said will be reflected when interest rates rise.

Goldman, Sachs & Co. analyst Richard Ramsden noted that despite debate on the timing of official interest rate hikes, they had already begun to be priced in by markets.

He pointed out that rate-sensitive banks had gained 25% for the year to date, versus gains of up to 17% for other banks, and against a 15% rise for the S&P 500. Bank of America Merrill Lynch has gained about 38%, while Wells Fargo Bank NA has gained 19%.

Futures markets also imply 25 to 50 basis points of hikes in 2015, while many banks have margin expansion baked into their estimates, Ramsden noted.

A rising interest rate environment is a broad positive for banks in that it signals a recovering economy where consumer and business confidence is higher, with banks likely to write more loans at fatter margins. Yet the mix of bank portfolios is key -- those with large mortgage books locked in at low long-term rates will suffer as their funding costs rise but the return on their loans falls.

"We estimate 11% average earnings per share upside for banks with a range as wide as 8% to -34%," Ramsden told clients.

"Rather than buying the stocks with the most absolute upside," he added, "we prefer relatively inexpensive names with relatively large EPS upside."

Such stocks include JPMorgan Chase & Co., Citigroup Inc., Fifth Third Bancorp and PNC Financial Services Group Inc., he said.

Similarly, both Deutsche Bank AG analyst Matt O'Connor and Barclays plc analyst Jason Goldberg rank America's biggest home lender, Wells Fargo, as one of the banks least well-positioned to weather rising rates. Wells Fargo has been the best performing bank among major Wall Street peers over the past five years, but perhaps foreseeing its exposure to rising rates, investors have pulled back -- causing it to underperform its peers over the past 12 months.

On the flipside, O'Connor ranks JPMorgan ahead of Citigroup and Bank of America as being best positioned for rising rates.

If the economy improves faster than expected and rates are raised next year, Ramsden said banks with asset yields tied to the long-end of the rate curve would likely see margin pressure and underperform. Bank of America and Citigroup fall into that basket. On the flipside, JPMorgan and Morgan Stanley were well placed given their excess cash and modest mortgage exposure, Ramsden said.

The Fed is cognisant of this interest rate risk, requiring America's 18 largest banks to submit stress tests that show how they would hold up under an economic shock such as a jump in interest rates or unemployment. Results are due July 5.

The Federal Deposit Insurance Corp. has also warned that the structure of bank balance sheets suggests greater sensitivity to higher rates than in 2004 -- the last time interest rates rose sharply. Long-term assets were 17% of banks' portfolios in 2004, but have since risen to 28%.

Written by Jane Searle in New York

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