Many investors' portfolios have taken a beating in the current inflationary environment. And many people new to investing are wondering what to do to protect their hard-earned money. One industry that has historically performed well when the Federal Reserve raises interest rates is banks. But I wouldn't just invest in any bank, as some banks perform better than others when interest rates rise. Here's why SVB Financial Group (SIVB.Q) is one of the best banks for your dollars in today's environment.
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SVB Financial benefits from rising interest rates
Most banks' primary business is in money lending. Banks typically borrow money from depositors and loan the money out to borrowers -- making profits on the difference between charging more interest to borrowers than the interest paid out to depositors.
Banks can increase profits when the Federal Reserve raises interest rates by raising interest rates for borrowers at a faster pace than the interest paid out to depositors. However, SVB Financial has two advantages that make it more effective in increasing its profits as interest rates rise.
First, 66% of SVB deposits sit in traditional checking or demand deposit accounts that pay no interest. In comparison, Factset reported in 2019 that median large bank holding companies held 22.7% of total deposits in accounts that pay no interest. -- meaning SVB pays depositors far less than other banks.
Second, SVB Financial predominantly originates business loans rather than home mortgages or consumer loans. Generally, rising interest rates make mortgages more expensive -- often making mortgage loan demand decline rapidly. In contrast, when interest rates rise in response to the economy doing well, it can have a neutral to slightly positive effect on business loan demand, especially in the earlier rounds of rate increases. Therefore, banks that focus on business loans rather than mortgage loans often have stronger loan demand in a rising interest rate environment.
As a result of SVB's business loan focus, its first quarter 2022 average loans grew by 45% year-over-year to $67 billion. In comparison, SVB’s first quarter 2021 average loans increased only 37% year-over-year, so loan activity appears to be picking up over the last year. More loan activity means more interest income, and when combined with lower interest paid to depositors, SVB profits can rise significantly as interest rates rise.
Accordingly, SVB's Q1 net interest income (NII), the difference between the interest SVB brings in and what SVB pays out, rose 15% over the previous quarter and up 64% year-over-year from Q1 2021. In comparison, Q1 2021 only grew 26% year-over-year.
In addition, SVB management recently raised its 2022 NII guidance from high 30s% growth to low 50s% showing SVB's increased confidence in tailwinds from rising interest rates. In addition, this guidance doesn't include the impact of eight expected additional rate hikes. If further interest rates do take effect, SVB Management expects each extra 25 basis points to create $100 million to $130 million worth of annualized net interest income.
The bottom line
The worst-case scenario for SVB is that rising interest rates eventually push the economy into a recession. Experts have been recently sounding the alarms on recession over the past few months. The latest was former Goldman Sachs leader Lloyd Blankfein saying that the economy has a very high risk of a recession.
Currently, rising interest rates have negatively affected loan growth for only some SVB clients, namely, venture capital and private equity companies. And even though SVB has strong loan growth tailwinds today from its high tech and the life science clients, a severe economic slowdown could crimp loan growth from all its clients -- negatively impacting SVB's net income. As a result, while SVB management expressed confidence about its loan guidance on its first-quarter earnings call, investors should monitor the effects of rising interest rates on SVB's loan growth each quarter.
SVB currently has a price to book ratio is 2.08, which is very high for a bank. However, SVB Financial Group's return on equity (ROE), a measure of profitability, is 14% compared to an average ROE of 12.28% for companies of a similar asset size -- justifying SVB's current valuation.
The upshot for investors is that today's market can be perilous for all companies. But if you expect interest rates to rise further, very few companies make for as solid an investment as SVB Financial.
