Banking is probably the most hated sector on the market today. Record low interest rates, questions over capital adequacy and litigation issues are all pushing investors away from the sector.
Who can blame investors for selling up? Shares in leading banks such as Santander(LSE: BNC) and Barclays(LSE: BARC) have been terrible investments over the past few years. Only the most foolhardy investor would want to buy these banks today... wouldn't they?
That being said, the outlook for these companies could be about to change as interest rates around the world wake up and return to more sustainable levels.
The interest rate issue
Banks' business models essentially require interest rates to be much higher than where they are today to succeed over the long-term. At its very core, a bank is essentially a risk assessor. Bankers take depositor cash and lend it to borrowers, who they believe are low risk, for a higher rate of interest than they are paying depositors.
In theory, this model should work in all kinds of interest rate environment as the bank is only pocketing the spread between interest received and paid out. However, as rates have been so low for so long, interest rates on credit products have fallen to record lows as banks chase business at the expense of margin, creating a headache for lenders. According to research from the US Federal Reserve the average interest margin at US banks has fallen by nearly a quarter since 2010 despite the rate hike earlier this year.
But this trend appears to be coming to an end, which is great news for banks such as Barclays and Santander. Rising bond yields around the world are pushing borrowing rates higher. UK lenders are rushing to hike lending rates despite the Bank of England's decision to cut its benchmark rate after Brexit.
Indeed, Nationwide has increased the rates on some of its 10-year fixed mortgages by 0.3%. Skipton Building Society increased rates on some mortgages by 0.37%, while West Bromwich, scrapped its market-leading 10-year fix and Virgin Money has increased the cost of borrowing across its mortgage range.
In the US mortgage rates have already increased by an average of 0.4% and UK mortgage brokers are predicting an average rise in UK lending rates by 0.25%. This is not a huge move on a single mortgage but for leading high street lenders such as Barclays and Santander, such a move could translate into hundreds of millions in extra profits.
Investors are already flocking to shares in Barclays and Santander ahead of higher profits. Over the past three months, shares in Barclays have gained 23%, and shares in Santander are up by 9% excluding dividends, outpacing the wider FTSE 100 which has lost 0.5% over the same period.
All in all, 2017 could be Barclays and Santander's year, as borrowing rates rise and the businesses can finally improve their returns on capital.
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Rupert Hargreaves has no position in any shares mentioned. The Motley Fool UK has recommended Barclays. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.