- The Bank of England increased interest rates from 0.1% to 0.25% yesterday.
- Banks are leveraged to the interest margin they can make on loans, this increases as interest rates rise.
- London quoted banks reacted as expected to yesterday’s interest rate rise by the BoE
Bank shares are leveraged to a number of different things. As we all found out the hard way a decade back they can crash if the economy does so. Default rates soar, bank stocks crater. Even, to the point that some go bust and others have to be rescued by government.
Another form of leverage is that banks live off the difference between the lending rate and the deposit rate. It’s that margin – minus defaults – that produces the income. As we noted yesterday this margin increases as interest rates rise. Or, the same statement, the currently artificially low interest rates compress bank margins.
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A rise in the general level of interest rates should therefore be good for bank margins and, to the extent that bank share prices move solely on this factor, for those bank share prices.
However, the effect is not going to be equal across all banks. A change in sterling interest rates will move those banks reliant upon sterling margins more than those less reliant. Which is just what has happened.
We said that Lloyds Bank (LON: LLOY) and NatWest (LON: NWG) would benefit more from this effect or rising interest rates and margins than Barclays (LON: BARC) and HSBC (LON: HSBA). Lloyds Bank and Nat West are largely to near entirely UK businesses, taking deposits and making loans in sterling. So, a change in sterling interest rates and thus sterling margins affects them. True, there are other effects on bank share prices, but Lloyds is up 5% on the back of the BoE announcement, NatWest is 2.3% up. HSBC does a lot of US $ and even HK $ business, the effect is less and the share price there is 2% up. Barclays has a strong investment banking operation which is less subject to this margin effect and Barclays is up 1%.
It is important to note that there are those other effects which change bank share prices. The general state of the economy and management tactics and at some point we should be sure that house prices will have an effect. So this effect of rising interest rates on margin spreads cannot be taken to be the one true determinant of what is going to happen to the London quoted bank stocks. However, the effect is there.
As always it is what happens next which is important. A current shared belief in The City is that now the BoE has started to raise interest rates it will continue to do so. Some are pencilling in 3 more rate rises next year to take rates up to 1%. This may or may not happen of course. But if it does then those differences in how the margin effect contributes to bank share prices is highly likely to repeat.