As the Fed ratchets down QE (the “taper”), we’ve been scouring bank financial statements for a clue as to the likely impact, including the eventual return to normalized interest rates.

We use JP Morgan as a case study, because it’s a decent proxy for the large bank environment: diversified, global, and well-capitalized.  In the three years from 12/31/10 to 12/31/13, JP Morgan’s loans outstanding grew from $693 billion to $738 billion, or about 2% annually.  During that same time, JP Morgan’s customer deposits with banks rose 11% per year, from $930 billion to $1.3 trillion.  With the practice of spread lending in a fractional reserve system, under normal circumstances, we might expect loan growth would out-pace deposit growth.  Over this three year period, deposits to banks exploded from $22 billion to $316 billion, or 144% per year for three years. That is, they’re continuing to put customer deposit money into their bank accounts, not lending it as much.   

JP Morgan is well-capitalized, it has now returned to its pre-recession dividend payout, its commercial and consumer loan customer base is much better positioned to borrow, and the economy is growing slowly.  Still, the bank prefers to keep cash at banks rather than lending it.  How does this make sense?

Since 2010, banks have been contending with tightening “net interest margins”, or the net interest income as a percentage of loans outstanding.  As the Fed lowered interest rates, banks retained some many legacy loans at higher interest rates, while they were able to reduce the interest they paid on customer deposit accounts to nearly 0%.  As time has drawn on, old loans have been paid back or refinanced now at far more favorable (for the borrower) rates.  The reason cash is piling up at banks?  In this environment with low net interest margins, banks can’t make any money. 

We think that bank lending will increase when the spread between what they can earn on loans and what they need to pay depositors increases.  That can’t happen when short rates are effectively zero.  We expect the Fed to be done with its taper program in 4Q14 and begin to raise interest rates in 1H15.  When this happens, we think banks will be more inclined to lend, leading to a virtuous cycle of economic growth.  Some of that may begin to happen earlier, as bank and borrower expectations about the future direction of interest rates is incorporated into loan applications and decisions.    

Rising interest rates are not a bad thing in and of themselves.  In the current case of our banking system and its likely impact on economic growth, we think higher interest rates will actually be very good for economic growth and in turn, corporate profits.

Peloton Wealth Strategists owns the common stock of JP Morgan Chase & Co.  The opinions expressed above should be construed as neither investment advice nor a solicitation to buy or sell securities.  Peloton Wealth Strategists assumes no liability for losses pursuant to investment actions entered into as a result of opinions expressed herein.  Changes in economic and capital market conditions and the unique objectives of each investor should be considered before investing in securities.