The Federal Reserve's impending tightening of monetary policy could significantly benefit U.S. banks. When the Fed raises interest rates, it will boost banks' net interest margins from multidecade lows and help them deal with an inevitable increase in provisions for credit losses, rising wages and technology spending, and pressures on some sources of fee income.

S&P Global Ratings believes the combination of higher rates and accelerated loan growth--spurred by the expanding economy--could drive a strong increase in net interest income for the banking industry this year with further increases in 2023 and 2024. While that improvement, by itself, wouldn't lead to many positive ratings actions--as we typically don't base ratings off cyclical changes in earnings--it would support banks' continued good profitability and creditworthiness.

In our base case--assuming the Fed can raise rates without causing an economic downturn--we expect the industry (all Federal Deposit Insurance Corp. [FDIC]-insured banks) to report a return on equity (ROE) of 9%-10% in 2022, supported by a roughly 10% rise in net interest income. While that ROE will fall from 2021's 12%--given last year's negative credit provisions--preprovision profitability will likely be better, and overall profitability will move closer to pre-pandemic levels. With net interest income climbing by a low-double-digit percentage in 2023, the industry ROE may inch over 10% with total earnings surpassing 2019.

Chart 1

Six Rate Rises Would Provide A Boost In 2022 And Beyond

Based on recent Fed announcements, S&P Global economists expect the Fed to raise rates six times this year starting in March, five more times total in 2023 and 2024, and to begin shrinking its balance sheet early in 2023 (see "The Federal Open Market Committee's Policy Rocket Heads To The Launchpad," Jan. 26, 2022).

We base our forecast for net interest income growth for the industry in 2022 and 2023 on our economists' assumptions and our own expectations for a variety of factors (see table 1). (For the purpose of this article, our forecast includes the entire industry, including unrated institutions).

We also base our forecast on an expectation that the economy will continue to grow even as the Fed tightens policy. In their most recent forecast from December 2021, our economists expected 3.9% growth this year and saw only a 10%-15% chance of recession. If their views change, we could become less optimistic in our forecast. We also assume that higher rates will not destabilize the economy due to heightened market volatility.

Based on our assumptions, we expect net interest income to grow each quarter in 2022 and 2023 (see table 2). With that growth, net interest income will well exceed 2019 levels even though net interest margins will still be lower than prior to the pandemic. That's because quantitative easing and other factors have caused banks' earning assets--on which they earn spread income--to rise by about a third compared to 2019.

Table 1

Table 2

Banks Look More Asset Sensitive Now Than In Past Cycles

Gauging interest-rate sensitivity is difficult and subject to a variety of factors. However, we believe banks generally are more asset sensitive (meaning their asset yields are likely to rise faster than their liability costs) currently than in past periods the Fed has embarked on tightening. That's partly because deposits make up more of their funding and they have larger amount of liquid assets than in the past.

We typically view favorably management of interest-rate risk that limits sensitivity in either direction. Unexpected material changes in rates are unlikely to damage banks with neutral sensitivity, and historically some banks have failed during certain periods due to extreme sensitivity positions. However, positive asset sensitivity should be beneficial in the current period.

Banks' good funding and liquidity should limit the pressure to raise deposit pricing as the Fed tightens. For instance, if loan demand increases, banks can redeploy liquid assets to satisfy borrower demand rather than having to increase deposit pricing to bolster funding. Net loans relative to deposits, a key funding ratio, is now below 60% for FDIC-insured banks, down from 72% in 2015 and about 90% in 2004--the previous two periods when the Fed started raising rates.

Despite this increase in asset sensitivity, our forecast for net interest income assumes that earning asset and liability betas will behave similarly to the rate tightening cycle that began in December 2015. Those betas compare the rise in earning asset yields and liability costs to the change in the effective fed funds rate. In a rising rate cycle, high earning asset betas and low liability betas are advantageous. We set them roughly equal to the last tightening cycle to be conservative and in consideration of the uncertainty of this exercise.

Most rated banks have also indicated that they believe they are asset sensitive. For instance, the country's three largest banks--JPMorgan Chase & Co., Bank of America Corp., and Wells Fargo & Co.--have all indicated they expect higher rates to materially boost their net interest income.

Likewise, most other banks have provided forecasts in their investor filings of how a change in rates would affect net interest income, usually assuming either an instantaneous or gradual 100-basis-point rise in short- and long-term rates. Almost all rated banks forecast an increase.

Those forecasts cannot be perfectly compared because they embed a variety of assumptions that can vary greatly, most notably assumptions about deposit-rate sensitivity. Still, the forecasts provide at least some indication of which banks may benefit most in the near term from higher rates (see table 3).

The median company-forecasted increase in net interest income is 5% over a year period. That is lower than our industry forecast for net interest income improvement in 2022, but the two figures are not completely comparable. That's partly because some banks assume static balance sheets and we incorporate growth. Also, some of the largest banks appear among the most asset sensitive, meaning an asset-weighted average would be higher than 5%.

Three trust banks--State Street Corp., The Bank of New York Mellon Corp., and Northern Trust Corp.--disclose the most asset-sensitive forecasts. However, they derive a lower proportion of their revenue from net interest income compared with most banks. While we typically look unfavorably on a lack of fee income, the banks most dependent on net interest income stand the greatest chance to benefit from rising rates, all else equal. For instance, the forecasted benefit to net interest income equates to a mid-single-digit rise in revenue for the trust banks. Several other banks with lower asset sensitivity but greater reliance on net interest income could see a similar or greater benefit to revenue.

Only two banks we rate, New York Community Bancorp and Investors Bancorp, project a decline in net interest income with a rise in rates. We believe both of those banks, which are large multifamily lenders and benefited when rates were falling, have a higher proportion of fixed-rate assets than most other rated banks.

Table 3

Growth In Net Interest Income Would Help Offset Higher Provisions

While U.S. banks should benefit from higher net interest income, they will also see increases in provisions and expenses. In 2021, FDIC-insured banks reported about negative $31 billion in provisions for credit losses as the rebounding economy allowed them to shrink their reserves for loan losses.

With those allowances relative to loans approaching pre-pandemic levels and loans growing, banks almost certainly will report positive provisions. In our base case, we expect provisions of $35 billion to $45 billion, equating to a rise of roughly $65 billion to $75 billion of provisions compared with 2021. That would still be below the $55 billion from 2019.

Banks' evolving expectations for lifetime losses on their exposures, net charge-offs, and loan growth will determine provisions (see tables 4-6). For instance, if banks become more pessimistic about lifetime losses--causing them to increase their allowances relative to loans--and net charge-offs rise meaningfully, provisions could rise above the 2019 level.

Table 4

Table 5

Table 6

Expenses Also Will Play A Large Part

Noninterest expenses rose 7% in the fourth quarter of 2021 compared with the year-ago period, fueled in part by rising compensation costs and spending on technology and other investments. Some of the rise in compensation related to greater business activity and some of the investment spending could result in more automation and reduced expenses in the future.

Still, expenses are on the rise in the near term due to a tight labor market and rising wages, as well as the need to make investments for competitive reasons, notably in digital initiatives and technology. Some banks have forecasted meaningful rises in expenses for 2022. JPMorgan, for instance, said it expected investments, and to a lesser extent, structural costs--including compensation--to drive a roughly 8% rise in noninterest expense in 2022.

Other banks have been more sanguine. For instance, Bank of America expects to hold expenses flat with 2021, and a number of regional banks have forecasted low- to mid-single-digit increases.

In our base case, we expect expenses to rise 3%-6% in 2022, driving an extra $15 billion to $30 billion in costs for FDIC-insured banks.

Fee Income May Be Flat To Down In 2022

Fee income has benefited significantly in the last year from especially robust activity in mortgage and investment banking, high asset values that have aided wealth and investment management, and other factors. We believe some of those results may not be quite as strong in 2022, leading to anemic fee income growth or potentially a decline.

For instance, with interest rates rising, mortgage originations and sales should fall, more than offsetting potential gains on mortgage servicing rights. Similarly, investment banking pipelines looked strong at the end of 2021, but matching last year's results will be challenging. If the recent drop in stock prices foreshadows a larger drop in asset values in general--due to higher interest rates--that could hurt areas like wealth and investment management.

Trading revenue, often the most difficult line item to predict, fell late in 2021 and also could be somewhat lower this year, particularly considering the strong results in the first half of last year. However, a robust economy and changing interest rates could help support a portion of trading activity.

Overdraft fees (including non-sufficient funds fee) also probably will fall. Bank of America, Wells Fargo, and several other banks have announced they are eliminating, reducing, or changing how they charge overdraft fees--motivated by a desire to be more consumer friendly and probably to reduce legal and regulatory risks. Other banks may follow suit. We estimate that those fees have made up about 1% of revenue for FDIC-insured banks during the pandemic and about 3% of preprovision net revenue (PPNR). Those ratios are also materially higher for several rated regional banks--often 2%-3% of revenue and up to about 10% of PPNR.

Finally, asset valuations play a key part in asset and wealth management and trust services, as fees relate in part to those valuations. If the sharp decline in asset valuations in early 2022 were to continue, this could also pressure fee income over time for select banks.

We Will Factor The Performances Of The Economy And Banking Sector Into the U.S. BICRA

In May 2021, we announced a change in parts of our Banking Industry Country Risk Assessment (BICRA) for the U.S. after observing positive developments in the U.S. banking system related mostly to the country's improved regulatory track record for banks, the good financial performance of its banks prior to and during the COVID-19 pandemic, and the rebounding economy (see "Various Rating Actions Taken On Large U.S. Banks And Consumer-Focused Banks Based On Favorable Industry Trends" and "Various Rating Actions Taken On U.S. Regional Banks Based On Improving Economy And Favorable Industry Trends," May 24, 2021).

We use the BICRA to set the anchor, or starting point, for our ratings on financial institutions in each given country. We said at that time the announced changes to the U.S. BICRA could, within one to two years, result in a higher anchor for the U.S. and therefore higher ratings on some banks. In addition, we may revise up the anchor if the current stringency of regulation remains in place, the economy continues to grow, and banks maintain strong balance sheets and good asset quality as they emerge from the pandemic. We continue to monitor those factors with a focus on the potential impact of the Fed's interest rate decisions this year on banks and the economy.