Making up for lower interest rates requires banks to be creative when it comes to filling the revenue gap. Image source: iStock/Thinkstock.
Wells Fargo (NYSE: WFC) isn't sitting around waiting for interest rates to rise. It's read the tea leaves, and according to the nation's third biggest bank by assets, it's best to assume that rates will stay lower for longer.
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This isn't good news for banks, most of which earn half or more of their revenue from net interest income. This comes from loans, as well as from fixed-income securities, such as U.S. Treasure bonds and government-insured mortgage-backed securities.
Lower interest rates reduce these assets' yields. Six years ago, when rates were higher, Wells Fargo's loan portfolio yielded 5.17%. Today, it yields only 4.16%. Given the amount of loans on Wells Fargo's balance sheet -- $951 billion worth -- that equates to $8 billion in foregone annual interest income.
Data source: Wells Fargo's quarterly earnings releases. Chart by author.
This explains why, for the last five years, banks have been prayingfor the Federal Reserve to increase rates. While it looked like this might happen after the Fed boosted short-term rates by 0.25% in December, the central bank has since tempered expectations of further rate hikes.
For Wells Fargo, this means getting ready for rates to stay lower for longer than originally expected -- though hopefully not for the two decades that short-term rates have hovered near 0% in Japan after a real estate bubble burst there in the mid-1990s.
The first way Wells Fargo is preparing for this is by growing its balance sheet. Here's the bank's logic: If each of its loans is going to yield less than it previously did, then one way to offset the impact on the top line is to grow its loan portfolio. And the same is true of its securities portfolio.
This is exactly what Wells Fargo did in the second quarter. The California-based bank's loans grew on a year-over-year basis by $80 billion, and its securities portfolio was up $18.5 billion. The net result is that, even though interest rates stayed low through the second quarter, Wells Fargo's net interest income rose.
The second way Wells Fargo is steeling itself for lower-for-longer rates is by maintaining discipline when it comes to expenses. This won't come as a surprise to longtime investors in the bank, given that it's long been one of the most efficient banks in the country.
Its efficiency ratio in the second quarter was 58.1%, meaning less than 60% of its revenue was consumed by operating expenses. This is at the high end of Wells Fargo's targeted range of 55% to 59%, but it's still one of the best efficiency ratios in the industry.
Finally, Wells Fargo is adding duration to its balance sheet -- i.e., buying and holding longer-term assets that yield more than shorter-term assets but will fall further in value if/when rates rise. It's tempting in times like these for banks to prefer shorter-duration assets, given the hope that rates will rise. But if rates stay low for an extended period of time, then the lower yield on the short-term assets will cause a bank's profitability to suffer compared to banks that are positioned for an extended environment of low interest rates.
The objective for banks at this point is to make the best of a bad situation. Wells Fargo is doing just that, by assuming interest rates will stay lower for longer. Its prediction hopefully won't come to fruition, but if it does, Wells Fargo will be ready.
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John Maxfield owns shares of Wells Fargo. The Motley Fool owns shares of and recommends Wells Fargo. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.