The Bank of England’s recent surprise decision to increase UK interest rates to 0.25% has sent reverberations around the financial sector. The first hike in three years is fantastic news for lenders such as Lloyds, Barclays, NatWest and Virgin Money. 

UK interest rates start to rise

At its core, a bank’s business model is relatively simple. It takes deposits from consumers and then uses them to fund other customers’ loans. As long as the bank receives more interest from borrowers than it is paying out to depositors, it should be profitable. That is after taking into account the costs of running the business and charges associated with loan defaults. 

In practice, that business model is a bit more complicated. In recent years, as interest rates have remained stubbornly low, lenders have been forced to seek out different ways to increase the return on their shareholders’ capital. 

Barclays has expanded its investment banking business. Lloyds has launched a wealth management division and is getting into buy-to-let ownership. Meanwhile, Virgin Money is concentrating on higher-margin credit card lending to increase its interest income. 

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

With interest rates pinned at 0.1%, well-capitalised lenders had little incentive to increase borrowing costs as it would have hit market share. The higher base rate may take some air out of the industry’s rush to grab new customers. 

Profits set to rise at UK banks

All in all, higher interest rates suggest profits will start to rise at UK banks over the next 12 months. Analysts are expecting further rate hikes next year, indicating this could be just the start of a series of interest rate increases.

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

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

Unfortunately, the interest rate increase benefits will not show through in these lenders’ profits immediately. It will take some time for the hike to work its way through to their bottom lines. Many large financial products such as mortgages are sold on multi-year fixed-rate deals. These are immune to rising interest rates. 

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

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

The post Why I’d buy banks as UK interest rates jump appeared first on The Motley Fool UK.

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