Are higher interest rates good for banks? “It’s complicated,” says analyst dick bove

The current upward trend of bank shares is mainly due to the conviction of investors that the interest rate and thus the banks' profits will continue to rise. "This is certainly true," writes bank analyst dick bove in a recent research paper, "but there is much more to this story."

A look back to the 70s

In a report released last monday, bove looks back to the 1970s to better understand how the banking sector is doing today. The 1970s were characterized by rapidly rising interest rates. Looking at how bank stocks fared then helps us get a sense of what we should expect today.

4 "inflation-proof" stocks to buy today! No doubt about it, inflation is soaring. Investors are unsettled. Money just sitting in the bank loses value year after year. But where should you invest your money? Here are 4 stock favorites from the motley fool's editors that you can invest in as inflation rises. We've seen some of the most profitable stocks of this generation like shopify (+6.878%), tesla (+ 10.714%) or mercadolibre (+ 10.291%) recommended early on. Hit these 4 stocks while you still can. Just enter your email address below and request this free report immediately. Request the free analysis now here.

In fact, bank profits were rising during that decade. Earnings per share at major banks – such as jpmorgan chase (WKN:JPM39E), bank of america (WKN:858388) and citigroup (WKN:A1H92V) – nearly tripled between 1971 and 1981, bove says.

Considering that banks make loans whose prices depend on the current interest rate, this also makes sense. Higher interest rates mean higher credit prices. And higher loan prices mean higher interest income for banks.

The paradox of the 1970s

Given that interest rates soared in the '70s (short-term rates rose as high as 18%), you might think the '70s was a great decade for bank stocks. Eventually, higher profits should lead to higher valuation multiples for banks.

US Key Interest Rate DATA BY YCHARTS

But here's what really happened: banks' valuation multiples moved in the opposite direction. The average price-to-earnings multiple of banks like jpmorgan chase, bank of america and citigroup fell from more than 13.0 in 1972 to less than 5.0 in just eight years.

What was responsible for this paradoxical result? In short, higher interest rates lower the prices of fixed-income securities (and those are a major component of any bank's investment portfolio). Bove says higher interest rates are good for banks only as long as the advantage of higher earnings outweighs the disadvantage of lower balance sheet value.

"What drove stock performance in the 1970s wasn't earnings, but a metric that we can't list here for the reason that it was never published – we're talking about book value. Rising interest rates led to effectively lower valuations of banks' assets. The drop in real book value could not be offset by growing profits."

Today and the 70s compared

Bove is absolutely right to point out that interest rates often don't affect bank stock valuations the way many believe they do. However, there are a number of other things in this regard that should not go unmentioned.

The first thing to note is that despite the fact that both decades were marked by rising interest rates, the 1970s and today were very different. The 1970s were extremely turbulent years for banks – and things got worse in the 1980s, when the U.S. Savings and loan crisis picked up steam.

The problem at the time was not simply fluctuating interest rates. Rather, it was the rapid pace at which they rose. The federal reserve was looking for a way to combat double-digit inflation rates. High inflation rates were a result of rising electricity prices, for which two oil embargoes initiated by OPEC during that decade were responsible. Today, there is no such trend to worry about. Since we still haven't fully digested the aftermath of the recent financial crisis, we shouldn't worry about a rapid rise in interest rates.

It's often the little things that determine whether a higher interest rate is good or bad for a particular bank. Image source: ISTOCK/THINKSTOCK.

Plus, banks handled interest rate risk differently in the 1970s than they do today. After jpmorgan chase's predecessors, bank of america and citigroup nearly filed for bankruptcy because their cost of capital (short-term rates) exceeded the income from their fixed-rate loan portfolios (long-term rates), they began making floating-rate loans.

This model is still used today. One could even go so far as to claim that modern interest rate risk management was invented in the 1970s. As a result of this model, higher interest rates today lead to higher profits more quickly than four decades ago – and the downside risks are also more manageable.

This is why bank of america is so asset-prone. A rise in the federal funds rate of just one percent would reduce the bank's interest income by 5.3 billion. Raise US dollar. Jpmorgan chase would then have to pay a further. And citigroup 2 billion. Earn US dollars.

In summary, bove is right that higher interest rates lead to higher revenues for banks, but at the same time lower their book value. This is why the pace of interest rate increases is so crucial. "Multiple increases in a short period of time do not help these stocks," says bove. "Moderate increases over a longer period of time already."

There is one company whose name is currently coming up very, very frequently among analysts at the motley fool. It is THE top investment for us for the year 2022.

You could also benefit from it. To do that, you first need to know everything you can about this unique company. That's why we've now put together a free special report detailing this company.

The motley fool does not hold any of the stocks mentioned above.