Banks have had a terrible time over the past six years and investors have suffered as share prices languish.
However, during the next 12months, banks fortunes should improve. And its all to do with the net interest margin.
Net interest margin
Put simply, the net interest margin is a measure of the difference between theinterestincome generated by banks and the amount of interest paid out to borrowers, relative to the amount of their interest-earning assets.
As a result, the wider the net interest margin, the more interest income thats generated by banks.
The percentage of interest paid out and received by the bank is linked to central bank interest rates.
Figures from the past 15 years can be used to show how banks rely on high central bank interest rates to boost profits.
During 2003/04, the federal funds rate, American central banks interest rate, hit a low of 1.0%. At this point, the average net interest margin earned by banks across the US was around 2.5%.
During the next three years, the federal funds rate moved steadily higher, reaching a high of 5.25% during June 2006. By this point, the average net interest margin reported by banks with over $15bn in assets had expanded to 4.0%.When rates rise, lenders try to raise the amount they charge for loans faster than what they pay on deposits.
As the financial crisis took hold, the federal funds rate was pushed down to an all-time low of 0.25% and net interest margins followed suit.
Moreover, as rates have remained depressed, net interest margins have continued to shrink.
Data from Forbes shows how harsh the interest rate environment has become for banks. Over the past three years the net interest margin at the five largest banks in the US has fallen from 2.81%, as reported for full-year 2012, to 2.68% for 2013 and finally 2.50% for full-year 2014.
Tiny change, huge profits
Even a small shift in a banks net interest margin can lead to a significant profit boost. Banking giantJPMorgan Chaseestimates that if its net interest margin were to increase by just 1%, the groups interest income would increase by $2.8bn per annum. A 2% increase would boost interest income by $4.6bn.
And analysts at Citigroup recently put out a set of figures detailing how Lloyds net interest margin is set to grow over the next few years.
Thanks to a reduction in Lloyds headline cash ISA savings rate, along with changes in how sensitive the banks other products are to interest rate movements, Citis analysts believe that Lloyds net interest margin will hit 2.7% during 2016/17 and 2.76% during 2018.
Unfortunately, after the recent court case, in which Lloyds lost the right to buy back its high-interest ECNs from investors, the banks net interest margin will be held back by 0.05%.
Nonetheless, analysts have hiked their earnings forecasts for Lloyds by 5% to 12% over the next four years based on a higher net interest margin.
All in all, as central bank interest rates increase banks earnings will receive a boost and shareholder are set to benefit.
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