The banking industry in 2016 is still struggling to recover from the Great Recession of 2008. The biggest taxpayer-funded bailout in U.S. history produced new challenges for U.S. banks. The weak economic environment in 2008 led to aggressive action by the Federal Reserve Bank (Fed) to lower interest rates. The historically low level of rates compressed the profitability of lending. At the same time, new regulations raised capital requirements and curtailed proprietary trading, which further squeezed profits.
Some analysts suggest a rise in interest rates might cure banks' problems. First of all, higher rates allow banks to generate larger spreads on loans. The low interest rate environment from 2008 to 2016 has punished bank profits. The European Central Bank (ECB), which sets key interest rates for the eurozone, has kept rates on its deposit facility negative, which severely impacts the ability of banks to make profits. Shares of Deutsche Bank AG (NYSE: DB), Germany's largest bank by assets, are trading near all-time lows.
Secondly, higher rates usually follow better consumer spending and wage increases. The improved economic environment could provide further stimulus for bank profitability. However, higher interest rates may lead to a stronger U.S. dollar, especially if U.S. rates move higher than rates in other countries. The question, then, is if a higher dollar helps U.S. banks.
Strong Dollar Helps Lending Profits
A flight to quality during the financial crisis propelled the Fed's U.S. dollar index (USDX) from 85 in July 2008 to 97 by March 2009. After that point in March 2009, the index began a slow descent that carried it to 80 by July 2011. After churning in the mid-80s for the next 3 and a half years, the index moved rapidly higher in 2015. An examination of net interest margins for U.S. banks over the same period shows that bank profitability suffered from the move lower in the dollar and gradually recovered as the dollar rose. Net interest margins measure the difference between banks' interest income and the interest they pay out to their lenders, and are therefore a key measure of bank profitability. Net interest margins declined from 3.83% in the first quarter of 2010 to 2.95% the first quarter of 2015. They then rose to 3.02% in the first quarter of 2016.
The correlation between the dollar and a key measure of profitability for banks is clear. Lower interest rates generally correspond with a weaker dollar. Although the Fed did not raise rates until December 2015, the move higher in the U.S. dollar index in 2015 anticipated tightening by the Fed. If the Fed raised rates and the dollar strengthened, the net interest margins may rise.
Strong Dollar Hurts Commodities
While the strong dollar may help net interest margins, it may not be beneficial to other bank businesses. Commodity prices also show a strong correlation with the dollar index. An examination of the U.S. dollar index and the price of oil shows that the two items have moved in an opposite direction over the last 10 years, though the extent of these moves has varied. Similar relationships exist between the dollar index and broader measures of commodities, such as the Thomson Reuters/CoreCommodity CRB Commodity Index. Market price global commodities in U.S. dollars and, therefore, commodities and the U.S. dollar generally move inversely.
Publicly available data from February 2016 shows that U.S. banks have significant exposure to the commodities sector. JPMorgan Chase & Co. (NYSE: JPM) had 6% of its wholesale credit exposure to the oil and gas exploration industry and 2% to the metals and mining sector. The bank had $550 million in reserves against its oil and gas exposure and $68 million against its metals and mining exposure. Meanwhile, Citigroup Inc. (NYSE: C) had 9% of its total exposure to oil and gas, 26% of which was to exploration and production. Citigroup had 32% of its exposure to non-investment-grade debt.
Key Takeaways
Strength in the U.S. dollar may create two contradictory results for the banking industry. On the one hand, dollar strength should produce continued weakness in commodity prices, which could significantly impact both the balance sheets and income statements of the largest banks. On the other hand, dollar strength should improve lending margins for banks. The question for investors is whether improvements in net interest margins can offset expected write-downs for bad loans from commodity investments. Regardless, strength in the dollar is not a simple panacea for bank stocks.
