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
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 3rd
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 3rd 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.
[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 3rd 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..
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