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Sunday, April 22, 2012

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,


*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?

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 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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