In the eight years since the Federal Reserve cut the federal funds rate to near zero in 2008, banks have been facing an uphill battle to maintain profitability. After the quarter-point rate hike in December 2015, their prospects brightened a bit as the outlook for interest rates showed signs of tightening. However, interest rates have continued to come under pressure due to a weakening global economy and fallout from the United Kingdom’s decision to leave the European Union (EU). With the outlook for interest rates remaining low for the foreseeable future, the profit picture is not very pretty for banks. However, there may be a silver lining as an unexpected boost in the mortgage side of the business could offset earnings pressures.

How Low Rates Are Affecting Banks

Most of the earnings pressure is coming from the narrowing spread in interest rates charged on loans and paid on deposits, which thins out banks’ margins. At the same time, the cost of funding has also been increasing. The yield curve, which plots the rates of long-term debt and short-term debt, has been flattening. Banks loan based on long-term rates and borrow money based on short-term rates. As they move closer together, it leaves banks with thinner margins and less profit.

The major banks, Wells Fargo & Company (WFC), JPMorgan Chase & Co. (JPM), Citigroup Inc. (C) and Bank of America Corporation (BAC), are all expecting lower earnings in the second quarter of 2016. Bank analysts have lowered their earnings per share (EPS) growth projections going into 2017. The financial sector has underperformed the stock market since 2006. Since 2011, it has returned just 14.70% compared to 28.06% for the S&P 500 Index. In 2015, the sector was down 1.03% versus a gain of 5.86% for the S&P 500 Index.

Banks Welcoming a Mortgage Revival

Historically low interest rates may turn out to be a double-edged sword for banks in the coming year. After slowing last year and into 2016, mortgage lending is picking up at a rapid pace. As a result of the continuing decline in interest rates, mortgage rates have fallen to levels not seen since 2013. The low rates have spurred existing borrowers to refinance and new borrowers to get off the fence. The big banks reported $115 billion in new mortgages during the second quarter, which is a 30% increase over the first quarter. Banks expect the trend to continue throughout the rest of the year, which will generate unexpected revenue. In fact, banks' low interest rates are boosting loan business across all categories, which is expected to contribute to banks' noninterest income as at least a partial offset to lower interest income.

Cut Here and Gouge There

Banks are continuing to do everything they can to cut costs, and they will find ways to increase fee income. Consumers are expected to bear the brunt on both sides. On the cost-cutting side, banks are likely to close physical locations or reduce staff. JPMorgan has managed to cut its operating costs by 6% over the prior year. On the expense side, consumers can expect an increase in bank fees, including overdraft charges, ATM fees and account fees.

Mergers May Pick Up

Although the big banks should be able to weather the storm, some regional banks may come under pressure to find suitors. Smaller banks are much more sensitive to interest rates, with less capacity to carry low margin loans. In some cases, they may be able to sell their loans to cushion their bottom lines, but it may not improve their earnings prospects if interest rates remain low. Thus far in 2016, there have been more than 150 mergers or acquisitions of small and regional banks.

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