Who's Ready to Cheer Rising Rates? The Financial Sector

As U.S. GDP and job growth continue to increase, the financial sector stands to finally get its wish: higher interest rates. After banks and insurance companies were gifted a bailout by taxpayers in the financial crisis, the Federal Reserve slashed its target interest rate to almost zero to enable banks to pay much less for the money they borrow to lend or invest. Now, nearly seven years after the crisis, those low interest rates are hitting banks where it hurts—revenue and earnings. Net interest margin, which is the difference between what banks charge for loans and what they earn on other investments, is at record-low levels. If interest rates stay historically low, this will get worse, not better.

If interest rates rise in an orderly fashion, the financial sector should see improvement in at least three areas:

This gets back to what banks are supposed to do—George Bailey style. As interest rates rise, banks will be able to invest excess cash at more attractive yields. However, the bigger factor for bank profits is being able to price loans at more "normal" rates, at least by historical standards.

When interest rates rise because of increased economic activity, the bond market yield curve tends to steepen. That means long-term rates rise at a faster pace than short-term rates because of a higher expectation of inflation. Because banks typically borrow money at the short end of the curve and lend money at the long end of the curve, a steepening curve is usually beneficial.

Along with the normal steepening of the yield curve, increased economic activity should increase the velocity of banking activities. Economic activity leads to business expansion and consumer confidence, which means more loans, more banking services, and more revenues. Incidentally, this hasn't been the case so far in the recovery, arguably because of persistently low interest rates.

Not all financial companies share the same outlook. For example, the largest U.S. banks don't really resemble banks anymore. They earn most of their income from more speculative ventures such as trading and capital markets (like mergers and acquisitions, stock, bond offerings, and so on), which tend to become more volatile when interest rates change. So rising interest rates may bring little benefit to their bottom lines, or worse, could be a disadvantage. Broker-dealers and insurance companies, however, are in a prime position to take advantage of higher interest rates without substantially changing what they're doing now. Along with a more attractive yield differential, an increase in economic activity could further drive revenue from a larger customer base and higher volume.