Photographer: Andrew Harrer/Bloomberg

Higher Interest Rates Would Throw Bank Profits a Lifeline

Having bailed them out and then helped to repair their balance sheets with record-low interest rates and bond-buying, policy makers may assist the financial industry once more when the U.S. Federal Reserve begins tightening monetary policy.

That’s according to two recently published reports by the Bank for International Settlements and McKinsey & Co., both of which have highlighted the downsides of ultra-easy borrowing costs in the past.

Based on seven years of data from 109 large international banks in 14 countries, the BIS confirmed a relationship between short-term rates and the slope of the curve for bond yields with bank profitability.

 The conclusion drawn by Claudio Borio, the head of the monetary and economic department at the BIS, and colleagues is that the positive impact of being able to earn income by lending money out for higher rates over time is bigger than the hit of defaults and income that doesn’t carry interest.

Even better news for the banks is that the effect is strongest when rates are lower and the yield curve isn’t that steep, as is now the case.

That provides another reason for the BIS’s economists to again decry the unintended side-effects of accommodative monetary policy. They reckon that between 2011 and 2014, the average bank of those studied lost one year of profits as a result of low rates.

“All this suggests that over time, unusually low interest rates and an unusually flat term structure erode bank profitability,” said Borio, Leonardo Gambacorta and Boris Hofmann in the report, which was published on Oct. 1.

Return on equity at 500 global lenders was unchanged in 2014 at 9.5 percent, about the average of the last 35 years, according to the Sept. 30 study by McKinsey. Profit margins also continued a steady decline, dropping by 185 basis points in 2014, in part because of lower rates. It reckons tighter policy would boost return on equity by about 2 percentage points.

“Many in the industry are waiting for an interest rate rise or some other structural lift to profits,” McKinsey said.

There is a sting in the tail. It warned that even if rates do rise, profit margins may still not return to their pre-crisis highs.

“Much of the benefit will get competed away, and risk-costs will likely increase, especially in economies where the recovery is still fragile,” McKinsey said.

 

Before it's here, it's on the Bloomberg Terminal.
LEARN MORE