Impact of an Interest Rate Hike on Bank Profitability: a Global Round-up

Pigeons, doves and flamingoes are some *species in which both the male and the female produce milk.

Yours, ever-amused by nature's diversity analyst,

AA

*clearly these are not species and it is even more clear that I am taxonomically challenged; can someone help me out with the correct word please?

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Those who are familiar with banking basics might want to skip the first three paragraphs.

One of the key differences between a bank and a non-banking financial institution (NBFI) is that banks are largely deposit funded.  Deposits are guaranteed by governments.  Other sources of funding do not carry a priori government guarantees.  Therefore the regulatory landscape for banks differs from that for NBFIs.  Differences in regulatory landscape account in large part for the difference in capital structure and competitive positioning between the two.

An interest must be paid on deposits.  This interest rate (IR) is floored at zero.  The deposits are lent out to clients that need credit.  The lending rate minus the deposit rate (henceforth, referred to as IR spread) is positive except in extraordinary circumstances wherein lending to sovereigns and central banks may carry negative spreads.  For the purpose of our discussion we ignore such circumstances.

We are living in rather extraordinary times.  Since the dawn of central banking, when viewed globally as opposed to looking at specific cases, IRs have never been as low and for as long a time.  And, for bringing these rather extraordinary times upon the world, thank you Bear Stearns, thank you Lehman, but before all that, thank you to the system that elevated home ownership in the US of A to the pedestal of a fundamental right.  Since IRs are at historical lows while deposit rates cannot fall below zero, the IR spread earned by banks are at historically low levels.  This is one of the (many) causes of depressed bank profitability since 2009.  The low IR environment has however prevented default rates from spiking while the world ploughs through the worst economic downturn since World War II.

A key question vis-à-vis future bank profitability projection is whether bank profitability will increase or decrease when IRs subsequently (say, by 2Q2013) rises.  [1]

I give my view below.  I cover all major regions except Africa, South America and West Asia.

Australia.  In case of an isolated rise in IRs, bank profitability will increase.  However, if the IR hike occurs during unexpected slowdown in China’s GDP growth rate then profitability will fall at banks with portfolio concentrations in mortgage and household lending sector but rise at those with concentration to the corporate sector.

Canada.  Profitability will rise with rise in IR except at banks with a high concentration in mortgages.

China.  Banks with concentrations in direct residential mortgages (I do not know any such major banks in China) will see a boost in profitability as even with a 40% fall in property prices default rates will remain modest.  Corporations in China, especially those coupled with the international supply chain, operate on rather thin margins.  Thus banks with a concentration in trade financing or lending to such corporations will have their margins eaten up by a spike in default rates.  In any case this analysis does not apply to major Chinese banks as PBoC will be ready to clean the slate for them when the time comes for that.  In an IR hike scenario, derivatives trading volumes will plummet causing (mainly foreign) banks to lose a a large chunk of their fee-based income.

Europe.  I guess I am stating the obvious here but for completeness let me state it anyways.  An IR spike will spell the death knell for most banks in Europe either directly or through contagion.  Low IR environment coupled with long-term repo operations is responsible for massive misallocation of capital in Europe. That is however necessary as Europe is standing at a point where it the choice is between low return on capital and no return of capital.  I expect this situation to last through at least 2Q2013.

Indonesia.  Irrespective of whether the IR hike is idiosyncratic or happens concurrently with an unexpected slowdown in China’s GDP growth rate, bank profitability will rise.  This is because the adverse effect of credit quality degradation accompanying the IR hike would be mitigated by low levels of leverage, strong domestic market and considerable room for further boosting capital expenditure.

India.  The conclusions for Indonesia apply to India as well.

Japan: While Japan’s GDP may have stagnated as a consequence of the 1987 Plaza Accord, its GNP has continued to track the growth rates in developing East Asia and more recently, that of India.  A hike in IR in Japan will be structurally fatal as it will force Japanese banks to recognize impairments on a large amount of assets and drive yen-denominated capital back into Japan where further capital investments are value-destroying and private consumption is expected to remain, at the best, stagnant.

Malaysia.  In case of an isolated rise in IRs, bank profitability will increase.  However, if the IR hike occurs during unexpected slowdown in China’s GDP growth rate then profitability will fall at banks with portfolio concentrations in mortgage lending sector but rise at those with concentration in the non-mortgage retail lending or the corporate sector.

Pakistan.  For Pakistan, looking at IR levels to obtain estimates of future profitability is like tarot reading.  Geopolitical risk dominates the profitability landscape in Pakistan.

Russia: Since the past 5 years, one principal component – the price of Brent crude oil – has practically dominated all other factors in setting IR levels.  IR levels are high when oil price is high has been concurrent with higher economic growth in Russia.  I expect this relationship to hold true in the foreseeable future.  Changes in IR levels are pro-cyclical with changes in credit quality, i.e., IR levels are high when credit quality is high and vice-versa.  Therefore IR hike will cause increase profitability as impairments will be minimal.

Turkey: In general, banks in Turkey are primed for increased profitability in an IR hike scenario.  It could however induce macroeconomic instability leading to a fall in bank profitability via second order effect.

UK: The analysis and conclusions presented for Europe hold true for the UK as well.

USA: There has been much whispering amongst the BRICS countries to shift to bilateral trade to bilateral currencies. I believe this will happen in the course of a decade or so but not now.  While the US was slowly losing its lipstick gloss, the Eurozone decided to get ugly in a hurry and whispers about Japan’s high gross sovereign debt/GDP ratio have already grown into murmurs in the international press.  This has put brakes on plans of several countries to diversify away from the use of Dollar in 3^rd party transactions.  Therefore I do not think external forces can corner the Feds into an IR hike [2].  Having discounted external causes of an IR hike, let us now look at potential internal causes.  An IR hike will lead to a significant inflow of capital causing a sharp appreciation of the Dollar, and of far greater concern given the fragility of international credit markets; it will cause a severe liquidity crunch in the dollar funding market.  As I have just pointed out, the world has NOT moved away from using the dollar in 3^rd party transactions.  I conjecture that on account of the Eurozone crisis, rather the opposite is true.  Therefore the Feds will have to organize a covert bailout of the world’s major central banks via additional dollar-local currency swap lines [3].  Thus I think that the Feds will maintain a low IR policy through at least 2Q2013.  Having discounted sharp rise in interest rates now let us take a quick look at what might happen if the IR rise is modest (say < 100 bps).  In this scenario deterioration of credit quality will dominate increased profits due to rise in IR spread.

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[1] on one hand, in a rising IR environment net interest margin (NIM) will rise but also, credit quality will worsen

[2] I am discounting the possibility of a China hard-landing scenario – it will force the Communist Party to liquidate a substantial portion of its external holdings sending Fed rates high, causing massive defaults in the US.

[3]  without a covert bailout, the world will be dis-incentivized from the use of Dollar in 3^rd party transactions; I do not think the US is prepared to yield Dollar’s status to a gold-holdings backed system or a system comprising several reserve currencies..

Münchner Sicherheitskonferenz 2012: eine Zusammenfassung von vier Reden

TILL DEBT DO US APART



Germany's POV


Same stuff, different days  1.1
You gambled and fumbled in a million ways  1.2
A decade of cheats, a decade of lies  1.3
No longer will work, your alibis  1.4
The banks are furious, the debt is due  1.5
The time has come to ring-fence you  1.6
It is too late to tell I told you so  1.7
Out you go, out you go ...  1.8


Greece's POV


The rise of Prussia, the fall of the Third Reich  2.1
We watched it all, with fear with fright  2.2
Across the pond, lies the American dream  2.3
Let us build it here, with Germany and team       2.4
First amongst equals, not a solo lead  2.5
A European Germany, not a Germanic retreat  2.6


Free trade, single currency  3.1
Many nations, still Europe's destiny  3.2
With barriers down, with Germanic productivity  3.3
Credit boom, became Southern reality  3.4


Bankers and a new vision for Europe  4.1
1999 and structured credit products  4.2
Bye-bye to 19% interest rates  4.3
Happy days in a happy place  4.4


2.2 - we refers to European nations
2.3 - pond refers to Atlantic Ocean
2.5 - paraphasing Chancellor Helmut Kohl who was the key architect of the fall of the Berlin Wall and the Maastricht Treaty which essentially created the new Europe
2.6 - here retreat refers to a place that is a secure resting place for troops
3.2 - destiny refers to geopgrahpic and cultural factors that make the presence of several nations in Europe unavoidable in the current age
3.4 - Southern refers to Southern Europe
4.2 - Euro was first introduced on Jan 1, 1999

With adaptation from the works of real poets,


AA
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The Munich Security Conference concluded on Feb 05.  It hosts a fairly open exchange of views amongst global policy, business and sovereign leads.

I summarize few of the speeches below.

Yours, enjoying London blanketed in snow analyst,

AA

Dr. JosefAckermann, Chairman, Deutsche Bank AG

My Summary: In Spain over 45% of the population under 25 is unemployed. Similar numbers for Italy and Greece. People in Europe are increasingly questioning whether they are part of a system that benefits them as well or are merely units to be used and profited from. The financial crisis is a crisis of trust. If actions fall short of restoring the trust then Europe would fall into disunity. With disunity Europe will lose the ability to shape international policy and instead each European nation would have to submit to externally recommended policy handouts. The young in Europe have not seen war and we must keep it that way. Political risks overwhelm risks of collective sovereign defaults. Europe needs both austerity and growth – an impossible combination so a fine balance is needed. The good thing about the European crisis is that balance in Europe can be restored endogenously. To restore the balance, Europe needs greater fiscal and political union.

My comment: Dr. Ackermann conspicuously does not mention a move towards a greater benefits or wealth transfer union as part of the solution.

Michael Diekmann,Chairman , Allianz SE

My Summary: Allianz provides catastrophe insurance globally. Over the past few decades catastrophes have both increased in frequency and intensity. This has increased the cost of damage insurance and the cost of insuring global supply chains. In the future, Allianz would find it increasingly difficult to provide the value it has delivered unless Europe tunes in one voice on Climate Change Policy. Another risk to Allianz is regulatory drive towards unbundling energy production, transmission and distribution. This will reduce investor flexibility, create new regulatory barriers and decrease liquidity. This drive in the energy sector parallels financial sector regulators’ drive towards unbundling banking services.

My comment ref insurance of global supply chains: Today, Allianz and the preponderance of US naval fleet are fulcrums on which the seamlessness of global trade rests. Without these fulcrums consumers cannot squeeze value out of continentally spaced economic endeavors. Without these fuclrums, the law of comparative economic advantages is a mere myth. We take the existence of fulcrums for granted, don’t we? Stability and global cooperation is more fragile than what people who are not responsible for ensuring these believe.

Zhang Zhijun, ViceMinister of Foreign Affairs, China

My Summary: Asia’s history is different from that of Europe. Asia has been a victim of colonialism. The West should recognize that Asians have the right to adapt development and peace initiatives to local conditions and the principle of gradual change in China’s context must be appreciated and understood by all. There is talk of power shifting from the West to the East. This is good for all, including the West as it occurs at a time when Western economies have been declining. Asia’s increasing wealth is the result of ingenuity and entrepreneurship of Asians. Asia’s wealth will help sustain employment in the West. China has been a partner in peace and stability in Asia. China has peacefully resolved border disputes with 12 nations. China continues to be an important partner in peace in the Korean Peninsula through a pivotal role in six-party talks. China will not take lightly reinterpretation in certain quarters of its own peaceful economic rise as the rise of a militaristic hegemon. Also, China is against the emergence of multilateral security architectures in Asia. China does not seek to impose its development model on anyone and expects the same in return.

My comment: I have long believed that if you owe your banker thousand dollars then it is your problem but if you owe him a million dollars then it is his problem. Upon appropriate scale transformation, the same should hold true where the banker and debtor are nation states. As America’s largest creditor, Zhijun does not appear concerned about debt that America continues to pile; debt that America neither has the ability nor the intention of repaying. What gives in?

My comment: Zhijun used the collective pronouns “we” or “us” when presenting his views except when he is talking about what China has done for the good of the rest of the world. For him, it is axiomatic that China’s view is Asia’s view.

Radoslaw Sikorski,Foreign Minister, Poland

My Summary: Sikorski echoes former German Chancellor Kohl’s view that ‘Germany is too big to be the first amongst equals but too small to dominate Europe’. In doing so, he quotes Kissinger who he less agrees with – ‘Germany is too big for Europe but too small to dominate the world’. Therefore Germany should not have hegemonistic intentions and should instead value its, still, very privileged place in Europe, that of Europe’s largest shareholder. Should Germany continue to work towards European solutions rather than be driven by hegemonistic intentions then it will, in Poland, find a very willing partner that will help Germany achieve its goals. Warning Germany to not even attempt to be a hegemon Sikorski quotes a WWII Polish Marshall who when asked why Russia is always a bigger security challenge than Germany said that whenever Germany gets too big for its own boots, Poland automatically has allies – powerful words indeed from a Polish minister spoken on German soil. He backs those up with theory and numbers as follows. The numbers are stacked against Germany and Germany fails the test of theory:

(i) The hegemon must have a preponderance of economic power: In 1949, the year of foundation NATO, the US economy was $1.3T, larger than the economies of Britain, Germany, France, Italy and Spain put together. This should be noted since today even though Germany is very rich, its GDP is $3.1T which is merely 25% more than that of France. Secondly, Germany's enormous trade balance is regional rather than of global signifiance; 9 out of its 10 largest trading partners are within Europe. Thirdly, a hegemon should command a large share of resources (which Germany lacks).

(ii) The hegemon must have a preponderance of military power: It should be a net provider of security to support the conduction of global trade. As of date the US spends $680 billion on defense which is larger than the rest of the world combined whereas Germany spends a mere $43 billion on defense. Therefore, there is no chance for Germany to become any meaningful net provider for security.

(iii) The hegemon must be perceived as benign (which is not so for Germany).

(iv) The hegemon must be perceived as capable of building and maintaining a liberal political and economic order (which needs to be yet demonstrated by Germany).

(v) The hegemon must be capable of providing public goods to a wider community (which Germany appears unwilling to and, even lacks the economic and institutional capacity for).