Only Rising Interest Rates Can Save Barclays PLC, Lloyds Banking Group PLC & Royal Bank Of Scotland Group plc

It’s been a dismal year for the big banks. Barclays (LSE: BARC) has had a particularly hard time, falling almost 20% over the last year, as it stumbles from one mis-selling scandal to another. 

Lloyds Banking Group (LSE: LLOY) had put on a decent spurt of recovery, but is now down 6% over 12 months. And that’s despite growing profits, a leaner UK focus, and the looming prospect of the return of its dividend.

Royal Bank of Scotland Group (LSE: RBS) is flat, despite reporting a surprise £2.65bn in first-half pre-tax profits, more than double the £1.3bn it posted one year earlier.

The banking stock recovery is slow and painful.

Bad Banks

Some analysts and investors have even abandoned banks altogether, notably equity income hero Neil Woodford, who recently dumped HSBC Holdings over fears that swelling regulatory fines could hit management’s ability to fund its dividend.

The banks are on the back foot, and it’s hard to see an easy way forward, but rising base rates could help dig them out.

Yes To Low Rates

Speculation continues to mount over when the Bank of England will finally get on with it. Some analysts stick by their (unlikely) claim that it could come as early as November. Others expect it in February.

Consensus has just shifted again. Money markets have pushed back the expected date of the first rate hike to August 2015.

The uncertainty over Scottish independence hasn’t helped. If they do vote Yes, the Bank may be tempted to keep rates low until the divorce is well underway.

Which would be bad news for the banks.

Housing Horrors

While rates remain low, it sends a clear signal that the economy is still on life support. Near-zero interest rates are in no way normal, although it’s beginning to feel that way.

For UK-focused banks Barclays, Lloyds and RBS, they’re a particular threat. The more their customers become used to low rates, the less they will prepare themselves for the inevitable increase.

A series of slow, steady rate hikes would concentrate minds, calm the housing market, and ultimately, reduce the number of repossessions.

Margin Gains

It will also help banks to boost their margins. Banks make most of their money on the different rates they pay savers and charge borrowers, but the spread has narrowed as base rates crashed.

That’s because mortgages and personal loans have become cheaper, but savings rates can hardly go lower, unless banks start charging customers to hold their money.

With the exception of trackers, it’s rare for banks to change their savings and mortgage rates in line with bank rate.

If base rates crept up by 0.25%, they might offer customers 0.15% on the new savings deals. Existing, loyal customers, usually get absolutely nothing at all.

That’s how the banks roll. It’s ugly, but it helps net interest margins.

Rising interest rates may also start to make deposit accounts and cash Isas look relatively more attractive, helping the banks to secure more money from savers.

It could also trigger a surge in lucrative remortgage business.

Double Trouble

Rising interest rates also pose a double danger. First, arrears and repossessions also increase. Two million say they will struggle to pay their mortgage if rates rise by just 2%, according to new research from Nutmeg.

Second, this could hit the market value of fixed-interest assets held by the banks. The Bank of England reckons that some 40% of assets held by British banks will have to be revalued if interest rates rose too quickly, hitting bond values.

The banks will also be indirectly exposed, if clients take a hit on their fixed-income securities.

Rising interest rates may offer the banks some reprieve. But they could also prove a double-edged sword, especially if rates rise too quickly.

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Harvey Jones has no position in any shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.