It’s been a wild year in the stock market. With inflation at its highest level in 40 years, the Federal Reserve is aggressively raising interest rates to bring it down. These actions have rippled through every market, from bonds to stocks to cryptocurrencies — all of which are down on the year.
While higher rates raise borrowing costs, one area of the economy welcomes them: the financial sector. That’s because many companies in the industry benefit by charging higher rates on loans to their customers. Big banks like Bank of America (BAC 0.86%) and JPMorgan Chase (JPM 1.19%) have increased interest income thanks to those higher interest rates. Here’s what rising rates mean for the economy and seven financial companies making money hand over fist.
This is the reason interest rates are rising
The Federal Reserve serves a key role in the economy and primarily influences monetary policy by adjusting interest rates. It sets the overnight lending rate between banks — known as the federal funds rate. Changes in this lending rate have ripple effects across all interest rate products, including mortgage rates, U.S. Treasuries, and municipal bonds.
When the economy slows, as it did in 2020, the Fed can lower interest rates to stimulate the economy, encourage more spending, and support asset prices. Low interest rates encourage borrowing as consumers refinance home loans or businesses restructure debt to take advantage.
When the economy runs too hot and inflationary pressures rise, the Fed raises interest rates to try to cool it down. Since March, the Fed has raised its effective federal funds rate from near zero to more than 3% — the fastest rate increase since 1980.
What rising rates mean for consumers and banks
Rising interest rates hit consumers who now face higher borrowing costs. According to data from the Mortgage Bankers Association, interest rates on a 30-year fixed-rate mortgage hit 7.16% at the end of this month — the highest interest rate since 2001. Higher rates have put pressure on housing affordability for many prospective homebuyers.
For consumers who save, higher rates mean you can earn more on a high-yield savings account or certificates of deposits that you buy today. For example, Ally Financial recently raised its savings account interest rate to 2.25%.
Banks welcome higher interest rates. That’s because banks traditionally make money on the interest rate spread, or the difference between the interest they earn on their loans and the interest they pay out on deposits.
When interest rates are low, the spread between the interest earned and interest paid out narrows and reduces the amounts banks make on the interest rate spread. When interest rates rise, this spread increases, enabling banks to earn more interest income.
The seven financial institutions reaping the rewards from higher interest rates
This year banks have made money hand over fist from net interest income (NII). In the third quarter, numerous banks have seen impressive year-over-year growth in NII. Here they are:
Several of these banks significantly benefited from rising interest rates because they have a large amount of noninterest-bearing deposits. These are deposits that the bank doesn’t pay interest on — giving it a cheap funding source that isn’t affected by rising interest rates.
Silvergate Capital (SI 2.88%) is a bank that serves cryptocurrency customers. Its noted product is the Silvergate Exchange Network, a payments network that helps crypto customers easily transfer U.S. dollars between exchanges such as Coinbase and Bitstamp. Because 99% of Silvergate’s deposits are noninterest-bearing, it reaps the benefits of rising rates without having to increase the interest paid on deposits. The bank’s net interest income this year has grown by 132%.
Bank of America, JPMorgan Chase, PNC Financial (PNC 1.16%), and Huntington Bancshares (HBAN 1.41%) all have a relatively large amount of noninterest-bearing deposits, too, ranging from 29% to 37% of their total deposits.
The financial services company Charles Schwab (SCHW 3.70%) had positioned itself for higher rates over recent quarters by increasing its cash holdings and reducing the duration of its investments — allowing it to take advantage and invest at higher rates.
Finally, Washington Federal (WAFD 2.58%) surprised investors when it crushed its earnings on Oct. 13. What helped the bank was a shift toward commercial loans and transactional deposits in recent years. Its commercial loans have floating rates and a short duration, perfect for the bank capitalizing on these rate increases. Transaction deposits are deposits like those in a checking account and lessen its sensitivity to the interest rate impact on its interest expense.
Banks benefit from higher rates, but there is reason to be cautious
Banks can be solid investments when interest rates rise because they can collect more interest income. However, investors have reason to be cautious. In the short term, higher interest rates can depress lending as consumers and businesses tighten their belts and demand for loans drops. That’s what has happened in the housing market.
According to the Mortgage Bankers Association, demand for mortgages is at the lowest level since 1997. Not only that, but companies with lower credit ratings have found it challenging to find lenders. Fewer loans means lower profits for banks, which could negate any gains they make on net interest income.
Banks will likely face some headwinds from slowing lending in the next few quarters. However, higher interest rates for longer could be a good thing for banks. That’s because they can collect more interest income than they did in the last decade and a half. And if that’s the case, bank stocks could be a solid part of your balanced portfolio.
Bank of America is an advertising partner of The Ascent, a Motley Fool company. Charles Schwab is an advertising partner of The Ascent, a Motley Fool company. JPMorgan Chase is an advertising partner of The Ascent, a Motley Fool company. Courtney Carlsen has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Coinbase Global, Inc., JPMorgan Chase, and PNC Financial Services. The Motley Fool recommends Charles Schwab and Silvergate Capital Corporation. The Motley Fool has a disclosure policy.