When Interest Rates Move, Some Banks Are More Equal Than Others
Richard Garstang
Managing Partner | Portfolio ManagerRichard Garstang joined OP in November 2006. He was previously employed by Man Securities as a research analyst covering the banking and specialty finance sector. He has also worked as a consultant for Deloitte in London and San Francisco. He graduated from St. Andrews University and is a CFA Charterholder. He is Managing Partner, co-manages the international portfolios, and contributes to the overall investment selection.
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Warren Buffett once said that “interest rates power everything in the economic universe” – and few sectors feel that power more acutely than banking. Understanding a bank’s interest rate sensitivity is not just an academic exercise; it’s central to evaluating its balance sheet strength, earnings resilience and ultimately its intrinsic value.
A critical part of this assessment lies in determining whether a bank is asset-sensitive or liability-sensitive. As active investors in financials, we pay close attention to how banks manage their exposure to rate movements – whether through structural hedges, asset-liability mix or shifts in strategic funding.
What Do We Mean by Asset-Sensitive and Liability-Sensitive?
At a basic level, ‘banks borrow short and lend long’. They typically fund themselves through short-term liabilities (e.g. deposits) and lend that out in the form of assets with longer durations (e.g. mortgages, commercial loans). The net interest margin (NIM) – the spread between interest paid on liabilities and interest received on assets – is a key driver of profitability.
Whether a bank is asset or liability sensitive – and to what degree – is largely driven by composition of its assets and liabilities and how quickly those assets and liabilities reprice to interest rate changes.
Asset-sensitive banks have assets that reprice more quickly than its liabilities. This means when interest rates rise, the interest income from loans and other earning assets increases more quickly than the cost of its liabilities, boosting profitability.
Liability-sensitive banks have the opposite setup: liabilities reprice quicker than assets. In a rising rate environment, this dynamic compresses margins and reduces profitability.
On the asset side, banks with a high proportion of variable-rate or short-dated loans tend to reprice quickly when rates change, boosting interest income. On the liability side, the mix of low-cost retail deposits versus wholesale funding determines funding sensitivity. A key concept here is Deposit Beta – a measure of how much of a change in market interest rates is passed on to deposit rates by a bank.
How Do Banks Manage Interest Rate Sensitivity?
Banks use several tools to manage interest rate risk. Gap analysis is one – comparing the amount of assets and liabilities that will reprice in different time buckets (e.g., 0-3 months, 3-12 months, etc.).
Another strategy is securitisation (and sale). U.S banks often securitise (or sell) fixed-rate mortgages to investors in Residential Mortgage-Backed Securities (RMBS). This transfers interest rate risk off the balance sheet and brings in fee income.
Banks also use derivatives such as interest rate swaps to hedge exposure and balance their interest rate risk. This is often referred to as a Structural Hedge. The structural hedge does not eliminate interest rate risk, but it cushions it – especially in the long run. The hedge also supports long-term planning and regulatory capital needs.
Case Study: Lloyds Banking Group
Lloyds, the UK bank, is held in a number of our strategies. It has a diversified asset base including mortgages, unsecured loans, car finance and commercial lending. Its funding includes both short- and long-term deposits, as well as wholesale borrowing. The exact mix moves around, with varying levels of fixed versus floating exposures depending on the make-up of the balance sheet at any given time. To help manage interest rate risk and smooth its earnings, particularly during periods of fluctuating interest rates, Lloyds employs a structural hedge.
This structural hedge provides a meaningful contribution to income. It helped support earnings during the low-rate environment and is now being reinvested at higher yields as it matures. The weighted average duration is 3.5 years, but it may take up to 7 or 8 years for Lloyds to get the full benefit of recent rate rises. In 2024, the structural hedge generated earnings of £4.2bn, accounting for one third of the group’s net interest income. Lloyds recently guided that the hedge income in 2025 will be £1.2bn higher, and then £1.5bn higher again in 2026.
A significant portion of this incremental revenue will fall through to profit. As this benefit comes through, we expect net income to grow by c. 50% over the next three years and help achieve its target of a 15% return on tangible equity. Earnings per share will likely grow quicker given the buyback that Lloyds is doing (c. 4% of market capitalisation per annum). At that point, Lloyds would be trading on a mid-single digit price-to-earnings multiple and below tangible book value.
Case Study: Ally Financial
Ally Financial, held in our Global All Cap Strategy, is liability-sensitive. It has approximately $135bn in loans – primarily auto loans – where yields are largely fixed for 5 to 6 years. This means the asset-side repricing has lagged as rates increased in recent years. Funding, by contrast, is primarily through deposits and wholesale sources that repriced (up) more quickly. Although Ally Financial does use hedging strategies to manage some of this exposure, in the rising rate environment experienced in the last few years, the combination of these dynamics has put downward pressure on the NIM.
However, with the rate declines that we have seen in recent months, we expect improvement in the net income profile of Ally Financial. Asset yields should rise as older loans mature and are replaced at higher rates, while funding costs may fall. Additionally, Ally Financial has been shifting its mix of funding toward more deposits (lower cost than wholesale funding), which should support net interest margin expansion and drive higher earnings.
Concluding Remarks
By analysing each institution’s sensitivity profile, we aim to identify opportunities and risks that aren’t always visible in the near-term. As we have highlighted with Lloyds and Ally Financial, understanding how financial institutions manage interest rate sensitivity through tools like structural hedges is crucial for evaluating long-term performance. These dynamics matter even more in today’s volatile rate environment, where expectations can change quickly and materially.
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