If the Federal Reserve raises interest rates, as many analysts and commentators expect it to do, then it's safe to assume that Bank of America will generate considerably more net revenue. This follows from the fact that Bank of America's balance sheet is "asset sensitive to both a parallel move in interest rates and a long-end led steepening of the yield curve," according to its latest 10-Q.
Three interest-rate scenariosThe best scenario is if both short- and long-term rates head higher. According to Bank of America's projections, a 100-basis-point increase (1 percentage point) in both short- and long-term rates will add $4.6 billion to its annual net interest income. Alternatively, a 50-basis-point drop (-0.5 percentage points) at both ends of the yield curve will result in a $3.5 billion reduction in net interest income.
Source: Bank of America's 1Q15 10-Q, page 109.
The second-best scenario for Bank of America is if long-term interest rates increase while short-term rates stay the same. In this case, assuming long-term rates go up by 100 basis points, then Bank of America's net interest income will move $2.4 billion higher. A roughly similar result comes about if short-term rates increase by 100 basis points while long-term rates stay the same.
Finally, as you may have already inferred, a downward shift in rates is bad for Bank of America across the board. If long-term rates drop by 50 basis points, its net interest income is projected to fall by $2.1 billion a year. And if short-term rates drop by 50 basis points, net interest income will decline by $1.4 billion per year.
Two caveats to keep in mindBefore you get too excited about the potential impact on Bank of America's stock price, there are two things to keep in mind.
First, while higher rates are good for Bank of America's net interest income, they have the opposite effect on noninterest income and on the value of the bank's available-for-sale investment securities. In the former case, this is because higher rates typically reduce demand for loans, which emit noninterest income when they're underwritten and sold. And in the latter case, this follows from the axiom that interest rates and the value of fixed-income securities are inversely related; as interest rates go up, securities values go down.
Secondly, Bank of America's projections assume, somewhat unrealistically, that there won't be a change in the size and mix of its deposit base. Consequently, as the bank acknowledges, "In higher rate scenarios, any customer activity resulting in the replacement of low-cost or noninterest-bearing deposits with higher-yielding deposits or market-based funding would reduce the Corporation's benefit in those scenarios."
These caveats aside, there is little doubt that a rising-rate environment will be good for Bank of America on net, as the positive impact of higher interest rates will all but certainly boost its revenue and make the still-ailing bank more profitable.
The article How Bank of America Will Benefit From Higher Interest Rates originally appeared on Fool.com.
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