Interest rates

Why would I buy banks when UK interest rates skyrocket

The Bank of England’s recent surprise move to increase UK interest rates at 0.25% sent reverberations in the financial sector. The first hike in three years is great news for lenders like Lloyds, Barclays, NatWest and Virgin money.

UK interest rates start to rise

Basically, the business model of a bank is relatively simple. It takes consumers’ deposits and then uses them to fund loans from other customers. As long as the bank receives more interest from borrowers than it pays depositors, it should be profitable. This is after taking into account the costs of running the business and the fees associated with defaults.

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In practice, this economic model is a little more complicated. In recent years, as interest rates have remained stubbornly low, lenders have been forced to look for different ways to increase their shareholders’ return on capital.

Barclays has expanded its investment banking business. Lloyds has started a wealth management division and is moving into rental property. Meanwhile, Virgin Money is focusing on higher margin credit card loans to increase interest income.

Ultimately, higher interest rates will allow these lenders to increase the cost of credit for borrowers. It should also reduce competition in the industry. Since the financial crisis, the banking sector has been overflowing with liquidity. Lenders have fought for market share, which has driven down the cost of loans across the industry.

With interest rates stuck at 0.1%, well-capitalized lenders had little incentive to increase borrowing costs as it would have affected market share. The higher base rate could ease the industry’s rush to attract new customers.

Profits set to rise in UK banks

Overall, higher interest rates suggest UK bank profits will start to rise over the next 12 months. Analysts expect further rate hikes next year, indicating that this may be just the start of a series of interest rate hikes.

If rates rise further, Lloyds, Barclays, NatWest and Virgin Money could see substantial increases in profitability over the next year.

This could be the start of a new period of plenty for these lenders as the financial world slowly begins to move away from the quantitative easing policies that have been in place since 2009.

Unfortunately, the benefits of increasing interest rates will not immediately show up in the profits of these lenders. It will take some time for the hike to work its way to their results. Many important financial products, such as mortgages, are sold through multi-year fixed rate transactions. These are immune to rising interest rates.

This means that there is no guarantee that profits will receive a boost. If the BoE were to cut rates again, profits could disappear overnight.

Nonetheless, despite this risk, I would be happy to buy Lloyds, Barclays, NatWest and Virgin Money as the recovery plays for my portfolio in the coming year. The double tailwind of rising interest rates and improving economic growth could help these companies outperform next year.

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Rupert Hargreaves has no position in any of the stocks mentioned. The Motley Fool UK recommended Barclays and Lloyds Banking Group. The opinions expressed on the companies mentioned in this article are those of the author and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. At The Motley Fool, we believe that considering a wide range of ideas makes us better investors.