How Will Banks Be Affected by a QE Slowdown?

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US banks have been recovering from the financial crisis at a good pace. Some are still struggling, but most of the pack is on the growth track and have cleaned their sour balance sheets. But what could happen if the Fed cuts its aggressive quantitative easing scheme? This could seriously hurt some banking stocks in the short-term as interest rates rise. This has already had some impact in the bond market as investors lost money amid increasing bond yields and could be the beginning of the end for the long bull market in this asset class. But the main question remains: when are rates going to rise?

Banks seek greater yields

Banks are looking for investments that result in more yield as the low-rate trap is affecting their earnings. The main options for these firms is relying on non-interest income, thus increasing fees, but this is not an option or they could lose consumers to the competition. The second, riskier alternative is long-term lending at low rates, or fixed rates. Investors looking for safer banking stocks should focus on the big banks that in some occasions have more sophisticated tools to counteract the interest rate risk: derivatives or interest rate swaps for example. Smaller banks cannot afford spending heavily on hedging instruments.

Bigger banks: better prospects

Bank of America (NYSE: BAC) is one of the banks that has recovered from the financial crisis and has successfully created a healthy balance sheet. The key data is that the bank posted a net interest income of $10.9 billion and a superior non interest income of $12.5 billion which indicates the bank is protected if interest rates increase. This is because if interest expenses rise (money paid to depositors), the bank has a safeguard in the noninterest income flow.

Bank of America is also controlling costs as it is operating with a very good efficiency ratio of 58.3%. Another important aspect is that the bank has been reducing its long term debt: from $335 billion to $280 billion and decreasing the net-charge offs from $4 billion to $2.5 billion from the first quarter of 2012 to the first quarter this year.

What about JPMorgan (NYSE: JPM)? The bank has a diverse product range and is geographically diversified so cash flows are relatively safe. Although its non interest income has reduced 11% to $569 million in the first quarter of 2013 compared to the same quarter last year, the company posted $6.5 billion in net income which has improved 32% in the same comparison period. This indicates that the bank is still capable of generating revenue even as net interest income falls. Finally, another positive aspect is that JPMorgan is one of the leaders in fees: it is #1 in global fees with an 8% of market share which should be tranquilizing for conservative investors.

Wells Fargo (NYSE: WFC) is another bank of this peer group that has the proper management and the strength to overcome a possible cut in the quantitative easing program. It is mainly focused in the US, but it has been gaining some market: it is the #1 small business lender, the #2 in US deposits, the #1 mortgage originator and the #1 middle market commercial lender. Its net income rose 22% from the first quarter of 2012 to the same quarter this year totaling $5.2 billion.

Another important point is its balanced revenue mix with 51% of its revenue being generated by non interest income and the rest with net interest income with a fee income over average assets in 3.1%, well above JP Morgan’s 2.5% and Bank of America’s 2.3%. Wells Fargo is an excellent choice for risk averse investors.

Bottom line

All of these banks are good choices for investors. Bank of America has achieved a healthy balance sheet by mitigating risks and reducing costs which will help it achieve stable growth in the coming years: It has increased its brokerage income, is recording higher investment banking fees (it is #2 in global investment bank fees,) and improved credit quality across all major portfolios.

JPMorgan is indeed one of the leaders in the banking industry. It has a diverse product range and geographical diversification that allows the bank to be a safe bet for prospective investors. This means that if it loses deposits, it will still be able to generate profits from other revenue streams: It is #1 in global fees. All of these reasons make JPMorgan attractive for investors that want exposure to the US financial sector.

Finally, Wells Fargo is a jewel in the segment. It is a leading financial firm in the small lending business, deposits, mortgages, and in commercial loans. This scale, combined with an excellent management team, will likely yield better growth prospects than most of its peers. It will also withstand a rate hike as it has a balanced revenue mix, with more than half of its profits being generated by non-interest income assets. These are some reasons that explain why Wells Fargo accounts for such a large part of Berkshire Hathaway’s equity portfolio, and should be considered for yours as well.

 

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Vanina Egea has no position in any stocks mentioned. The Motley Fool recommends Bank of America and Wells Fargo. The Motley Fool owns shares of Bank of America, JPMorgan Chase & Co., and 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. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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