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Why Investors Should Buy Banks Before Interest Rates Rise

Banks have had a terrible time over the past six years and investors have suffered as share prices languish.

However, during the next 12 months, banks fortunes should improve. And it’s all to do with the net interest margin.

Net interest margin

Put simply, the net interest margin is a measure of the difference between the interest income generated by banks and the amount of interest paid out to borrowers, relative to the amount of their interest-earning assets.

As a result, the wider the net interest margin, the more interest income that’s generated by banks.

The percentage of interest paid out and received by the bank is linked to central bank interest rates.

Case study 

Figures from the past 15 years can be used to show how banks rely on high central bank interest rates to boost profits. 

During 2003/04, the federal funds rate, American central bank’s interest rate, hit a low of 1.0%. At this point, the average net interest margin earned by banks across the US was around 2.5%.

During the next three years, the federal funds rate moved steadily higher, reaching a high of 5.25% during June 2006. By this point, the average net interest margin reported by banks with over $15bn in assets had expanded to 4.0%. When rates rise, lenders try to raise the amount they charge for loans faster than what they pay on deposits.

As the financial crisis took hold, the federal funds rate was pushed down to an all-time low of 0.25% and net interest margins followed suit. 

Moreover, as rates have remained depressed, net interest margins have continued to shrink. 

Data from Forbes shows how harsh the interest rate environment has become for banks. Over the past three years the net interest margin at the five largest banks in the US has fallen from 2.81%, as reported for full-year 2012, to 2.68% for 2013 and finally 2.50% for full-year 2014.

Tiny change, huge profits

Even a small shift in a bank’s net interest margin can lead to a significant profit boost. Banking giant JPMorgan Chase estimates that if its net interest margin were to increase by just 1%, the group’s interest income would increase by $2.8bn per annum. A 2% increase would boost interest income by $4.6bn. 

And analysts at Citigroup recently put out a set of figures detailing how Lloyds‘ net interest margin is set to grow over the next few years.

Double-digit growth

Thanks to a reduction in Lloyds’ headline cash ISA savings rate, along with changes in how sensitive the bank’s other products are to interest rate movements, Citi’s analysts believe that Lloyds’ net interest margin will hit 2.7% during 2016/17 and 2.76% during 2018.

Unfortunately, after the recent court case, in which Lloyds’ lost the right to buy back its high-interest ECN’s from investors, the bank’s net interest margin will be held back by 0.05%.

Nonetheless, analysts have hiked their earnings forecasts for Lloyds by 5% to 12% over the next four years based on a higher net interest margin.

Growth picks

All in all, as central bank interest rates increase banks earnings will receive a boost and shareholder are set to benefit.

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Rupert Hargreaves 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.