The single most important question for investors in Bank of America (NYSE: BAC) right now is this: How much additional revenue will the bank earn when interest rates rise?
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To understand why this is so important, it's helpful to think about a bank as a retail store that sells money (by making loans). The price of the money a bank sells is denominated in interest rates. If rates go up, so too will the price of money. And if the price of money goes up, so too will a bank's revenue.
Bank of America's headquarters in Charlotte, North Carolina. Image source: Getty Images.
This has been a problem for banks over the last few years because interest rates dropped to nearly 0% in the wake of the financial crisis. The shortest-term rate, the federal funds rate, which is how much banks charge to lend each other excess reserves on an overnight basis, has been less than 0.2% for much of the past decade after averaging nearly 6% in the preceding half-century.
As a result, Bank of America has seen the amount of money that it generates from its portfolio of loans and other assets decline. In 2007, its interest-earning assets yielded 2.75%, after deducting funding costs. Today, they net 2.25%. That may not seem like a huge difference, but the 50-basis-point decline translates into $9.3 billion worth of high-margin revenue. After deducting taxes, that could increase Bank of America's annual earnings by upwards of 50%.
It's for this reason that bank stocks have responded so favorably to rising interest rates. The Fed has now raised short-term rates twice since December 2015, each time by 25 basis points, most recently at the end of last year. And there's talk that it could do so as many as three times in 2017 according to the Fed's latest dot plot.
If you're a current or prospective investor in Bank of America, you'd be excused for wondering how much this will help the North Carolina-based bank. The answer is: a lot. You can see this by looking at its annual regulatory filing (here's the link if you want to follow along) for 2016.
On page 84, you'll find a table titled: Estimated Banking Book Net Interest Income Sensitivity. That's a complicated way of saying that this is how much more net interest income (revenue) Bank of America will earn under six different interest rate scenarios.
Data source: Bank of America's2016 10-K, page 84.
The scenario that we want to look at is the top one, which shows what will happen to Bank of America's net interest income if short- and long-term rates both rise by 100 basis points, or 1 full percentage point. And the answer is: It'd increase the bank's net interest income by $3.4 billion a year, or $850 million a quarter.
This is a little optimistic because it assumes four rate hikes, not three, but it still gets investors in the ballpark. Moreover, while higher rates are good for a bank's income statement, they're bad for the balance sheet, because higher rates cause the value of fixed-income securities on a bank's balance sheet to fall.
These caveats aside, it's also worth keeping in mind that Bank of America is already set to earn $600 million in added net interest income this year as a result of the rate hike in December. Any benefit from rate hikes in 2017 will thus be on top of this. The net result is that Bank of America could very realistically see a double-digit year-over-year increase in its earnings in the quarters ahead.
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