Over the last 20 years we have noticed interest rates have been much lower than the previous 20 years, reaching new lows after each cycle. Accommodative monetary policies have become the standard tool to jumpstart economies after each downturn. This is no different in 2020 as we feel the effects of COVID-19 where long term interest rates have again fallen to the same levels as those experienced in the GFC. Low interest rates usually stimulate the financial equities markets by increasing spending and credit, lowering the discount rate and making the higher returns provided by equities more attractive. However, do we see the same effects in the banking sector which has a unique and more direct relationship with interest rates?
Interest rates in Japan and Europe have been at or below zero for the last decade which has also coincided with significant downwards pressure in the stock price of each regions banking sector. I want to investigate the validity of a causal effect in this relationship and how it may affect US banks in the next decade as the US heads back towards the zero lower bound and potential negative rate territory.
Banking Sector Performance in a Low Interest Rate Environment
Following the global financial crisis all three bank indices in the US, Japan and Euro area saw their prices drop more than 60% (see Fig. 1). Banks in Japan and the Euro area never saw their prices make meaningful recoveries since in the backdrop of zero to negative interest rates. However, banks in the US recovered to their 2007 highs in the backdrop of increasing interest rates.
An argument could be made that this could simply be a reflection of the US stock market having had one of the best bull markets this last decade whilst both Japan and Euro stock markets have struggled. The counter argument is that although the US bank index (KBW) has largely tracked the US market index (SPY) both the Japan and Euro bank indices (TOPIX and SX7E) have de-coupled from their respective market indices (Nikkei and EURO Stoxx 50). Both the Nikkei and EURO Stoxx 50 have largely recovered their losses from the GFC but again the banks in either region have not.
Another argument one could make is that the difference in price growth could be due to a result of the proliferation of share buybacks that has occurred in the US stock market compared to that of Japan and the Euro area. Banks also usually yield high dividends which are not reflected in the chart in Fig. 1. I don’t have the data to explore the impact of share buybacks and dividends further, but I assume the significant divergence in the indices are little explained by share buybacks and dividends alone.
For the same trends we see in Japan and Europe to hold true in the US an assumption must be made that the Federal Reserve (FED) will hold interest rates near or potentially even below zero for a significant period. I believe there is a high probability that this will be the case as we saw in 2018 tightening monetary policy resulted in fear in the financial markets. It will become ever more difficult for reserve banks to unwind reserve assets and pull back from accommodative policies as low interest rates become the framework on which the new economy is built on.
Interest Rate Effects on Bank Profitability
First, I want to examine the effect of reserve bank interest rate policies on bank profitability. The impact that interest rate changes will have will depend on a range of variables such as the banks asset and debt portfolio, the maturity gap between its assets and liabilities and non-interest portion of income (such as fee income for products and services).
The effect of lower interest rates on profitability come directly from the level of rates and the yield curve. The effect of the level of interest rates can be summarized as follows:
- Banks partially fund their operations with retail deposit at rates set as a markdown on market rates. This markdown is compressed as interest rates decrease because the deposit rate cannot fall below zero. Therefore, as interest rates decrease, the net interest rate margin on banks also decreases.
- Lower interest rates will generally induce more lending and investments in riskier assets in search for higher returns. This is the whole point of accommodative monetary policy (low interest rates) and may increase net interest rate margins. However, this depends on economic conditions as a weak economic outlook (precisely the reason why rates may be low) can limit demand for loans.
The effect of the yield curve is explained by the operation of banks taking short-term loans and granting longer term loans. Therefore, net interest rate margins are compressed when the yield curve flattens and increased when the yield curve steepens.
If we examine the net interest rate margin of banks in all three regions, we see an overall downtrend, in-line with that of central bank interest rate policies (see Fig. 3). The net interest rate margin is lowest (Japan) for the region with the lowest average interest rate over the last 20 years and vice versa (US). The average net interest rate income growth follows the same trend, where the growth is lowest (Japan) for the region with the lowest average interest rate over the last 20 years and vice versa (US).
In all three regions, despite a low interest rate environment, the average net interest income portion of total income remains steady (except for the period following the GFC). Banks have seemingly not been able to supplement the loss in net interest margin with non-interest income through this period.
In conclusion there will likely be downwards pressure on the income and share price of bank stocks in the US in the next cycle. I don’t believe we will see the same catastrophic failure of the banking sector like we saw in the GFC. Banks are extremely well capitalized with healthy liquidity and stable funding rates following the GFC and resulting stringent regulations through Basel III. Liquidity issues have been further dampened by the FED initiating ‘infinite QE’ and buying up seemingly every type of asset save for equities.
Disclaimer: This information is only for educational purposes. Do not make any investment decisions based on the information in this article. Do you own due diligence.