It’s been a mixed year for FTSE 100 stocks. The index has been hauled upwards by surging resource and oil stocks. But many sectors have suffered.
One such area is banking. Banks, notably consumer banks — those that lend money to individuals through loans, mortgages and credit cards — generally tend to be classified as cyclical stocks.
This is because the demand for their services increases during periods of increased economic activity and decrease when economic activity wanes.
In fact, when economies go into recession, like we’re seeing in the UK now, banks see an increase in bad debt, pushing up impairment charges. This is a headwind.
But right now, these banks are experiencing one major tailwind.
Interest rates
The Bank of England (BoE) kept interest rates near zero for much of the last decade. But things changed in 2022 as inflation surged to levels not seen in my lifetime. Now, the BoE base rate is 3.5%.
And this is important for banks as it allows them to increase their net interest margins — this is the difference between lending and savings rates. Banks, as we all know, don’t pass all of their lending income onto their savings customers.
But there’s another big boost. And that’s the fact that banks are earning more interest on their central bank deposits. In the case of Lloyds, every 25-point basis hike is worth around £200m in interest income solely from central bank deposits. The BoE has push rates up by 325 points this year, so the net gain is considerable.
Net interest income sensitivity
Lloyds, Barclays, NatWest and HSBC, form the so-called ‘Big Four’ banks in the UK. And while all of these institutions will benefit from higher rates, some will benefit more than others.
That’s because the net interest income of some banks is more sensitive to changes in interest rates than others. This can be due to several factors.
Lloyds appears to be the bank with the greatest net interest income (NII) sensitivity. This is due to its funding composition and business model — Lloyds, for one, doesn’t have an investment arm.
For example, Lloyds’ business activities is funded primarily by customer deposits — 70%. By comparison, at Barclays, customer deposits only represent 34% of total funding.
Moreover, due to ring-fencing regulations, Barclays cannot use customer deposits to fund its investment banking activities. Although Rishi Sunak’s government has highlighted its willingness to reconsider the ring-fencing rules that were brought in after the financial crash.
NatWest is also more rate sensitive than Barclays and HSBC due to its business and funding model.
Where next?
Interest rates aren’t expected to fall in 2023. The market is predicting that the BoE base rate will rise above 4% in early 2023 and as high as 4.6% by July 2023. It could even go higher.
The most dovish estimates see rates falling to around 2% in 2025 — that’s still way above levels seen over the last decade. There are no UK long-term interest rate forecasts beyond 2025.
So while growth momentum might be slowing, and there are headwinds such as needing to put more money aside for bad debts, higher interest rates look here to stay. I own stock in all of the aforementioned big banks. But I’m particularly keen on Lloyds and Barclays, due to their attractive valuations.
