Before You Sell Your Bank Stocks...

Many financial institutions are now insulated against higher interest rates

When interest rates go up, investors traditionally flee bank stocks. Their logic seems ironclad: As rates move higher, banks must offer higher rates to depositors to stay competitive. But if they can't quickly charge borrowers more as well, their profit margins get squeezed. True to form, as expectations of a rate hike have gained momentum, bank stocks have taken a beating, falling nearly 8% from a peak in March, vs. a 5% decline for the market as a whole.

This time around, investors may come to regret their time-tested reaction. In recent years, many banks have expanded into businesses that are less sensitive to interest rates. Others, in anticipation of higher rates, have begun to grant fewer fixed-rate mortgages and hedge existing loans against rate rises. The stronger economy, meanwhile, should lead to both greater loan demand and fewer write-offs for bad loans. So analysts expect that the 36 banks in the Standard & Poor's 500-stock index will earn a combined $91 billion this year, up 9.6% from 2003, according to Reuters Research. "What you're seeing on Wall Street is just a knee-jerk reaction," says Russell Goldsmith, chairman and chief executive of the Beverly Hills-based City National Corp. (CYN ), which has $13 billion in assets. "The truth is, at some institutions earnings will go up if rates rise."

Diversification explains a big part of why the impact of higher rates could be less dramatic than before. The 50 largest U.S. banks now get 40% of their earnings from fees generated by the likes of investment banking, asset management, and insurance, up from 26% in 1990, according to Ryan Beck & Co., a bank-stock research firm. At many large financial institutions -- Northern Trust, Bank of New York (BK ), First Horizon National (formerly First Tennessee National (FHN )), PNC Financial Services (PNC ), and State Street (STT ) -- such activities account for more than half of total revenues. Changes in interest rates don't have any direct influence on fee-earning businesses. Investment banking and brokerage earnings, for example, are expected to climb as the market for mergers and initial public offerings heats up.


To be sure, the biggest factor influencing bank earnings is still the difference between the rates they pay depositors and those they charge borrowers -- a spread that's now at a 10-year low. Still, many banks are protected because they gather deposits through noninterest-bearing accounts. At Commerce Bancorp Inc. (CBH ), a fast-growing outfit based in Cherry Hill, N.J., that keeps branches open seven days a week, such accounts make up nearly a quarter of its $22 billion in deposits because clients seem to value good service over earning interest. Says Vernon Hill II, the bank's chairman and president: "Our cost of money is very, very low."

Many bankers have commercial loan portfolios that benefit from higher rates by lending to businesses at floating rates. At Sovereign Bancorp Inc. (SOV ), a large community bank in Philadelphia, some $10.8 billion of its loans float in tandem with market rates while only $8.8 billion of its liabilities do so. Jay S. Sidhu, the company's chairman and chief executive officer, figures that a two-percentage-point increase in rates will lift Sovereign's interest income by $70 million. "We can't wait for rates to start rising," he says. "We've been waiting for two years."

Rates, of course, usually rise when the economy starts rebounding -- another plus for banks. While that has yet to translate into a raft of new business loans, it has improved the quality of existing ones: Net charge-offs have sunk to 0.38% of average loans -- half of what they were two years ago. Smith Barney bank analyst Ruchi Madan forecasts an 8% rise in business loans over the next 12 months, boosting bank earnings by about 2% on average and offsetting much of the downside of higher rates.

Federal Reserve Chairman Alan Greenspan should take heart. He'll still have some fans out there once he starts to tighten the screws.

By Christopher Palmeri in Los Angeles and Mara Der Hovanesian in New York

    Before it's here, it's on the Bloomberg Terminal.