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By Christopher Baker, CFA | 06-30-2017 10:00 AM

Flattening Yield Curve Limiting Bank Profitability

A smaller gap between short- and long-term rates has limited the ability of banks to boost profits, says Morningstar's Christopher Baker.

Christopher Baker: Themes in U.S. bank credit thus far in 2017 include stable-to-improving profits, somewhat higher capital levels, amid some deterioration in asset quality in the credit card sector.

One factor contributing to the higher profitability recently is higher short-term interest rates. In June, we saw the third rate hike in this cycle of the Federal Reserve's tightening campaign. Generally speaking, higher interest rates contribute to higher levels of net interest income, a component which represents about half of bank revenue. However, since the beginning of the year, long-term interest rates have rallied causing the Treasury yield curve to flatten to a spread of 78 basis points from 125 at year-end. This flatter yield curve limits the benefit to banks from borrowing short and lending long.

During the first-quarter, we noted some deterioration in asset quality among the credit card lenders. On average, net charge-offs and delinquencies increased about 30 to 50 basis points from a year earlier. We attribute this weakening to aggressive lending a year-ago that's now coming home to roost.

The Federal Reserve recently released its stress test results on 34 of the largest U.S. banking groups. This was the first year that all banks passed and had their capital plans approved. We expect these results to contribute to higher capital payout ratios for banks the remainder of this year. However, the Fed echoed concern over asset quality in the credit card sector in the tests by requiring American Express and Capital One to re-submit their capital plans.

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