Banking: The known unknowns

If there were a common depiction of the outlook from the latest bank earnings reports in Australia, the Asia Pacific, Europe and the US it would be of a summit or at least a plateau. Things can’t get much better, they can get worse.

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The rising global interest rates of the last 18 months have benefited bank margins but the collateral damage done to economies is yet to show up in a decline in credit quality or hefty slowdown in revenues. Meanwhile the inflation rising rates are aimed at quelling is increasingly evident in cost-to-income metrics.

"Banks are a proxy for the broader economy. While history tells us they are more than capable of finding ways to blow themselves up, more typically they have failed to manage the risks of their customers.”

To use the anemological terminology favoured in earnings calls, the headwinds are growing, the tailwinds dissipating.

We’ve already had an inkling of the kind of “known unknown” impacts of rising rates with the collapse of several US regional banks and the forced merger of one globally systemically important one. That is, we know the changing rate environment is going to break things, we’re just not exactly sure what.

In a new research document, produced after this recent mini-crisis, the global banking regulator, the Bank for International Settlements (BIS), noted “while regulatory requirements are fundamental, they cannot, in isolation, address all ways in which higher rates could impact a bank’s solvency and liquidity.

“Moreover, capital requirements are sensitive to banks’ accounting classification choices, while liquidity rules are premised on assumptions about deposit stickiness and the ability to sell assets at a reasonable cost.”

So not a lot more clarity from the global regulator.

Those crashed banks were culpable in several ways: some failed to manage the interest rate risk they had in their investment portfolios; some were over-exposed to a narrow depositor base which had in turn not realised the risk they were running in having high levels of uninsured deposits; some simply suffered the general malaise of having eroded trust in their brand.

That these particular banks would be the first high-profile victims of rising rates was not something experts predicted even six months ago. So too - as is always the case – it will be hard to be precise about exactly where things will crack as the tighter economic conditions constrict.

As the BIS says: “a rapid increase in interest rates may adversely affect a bank’s loan quality, placing downward pressure on loan valuations.  But, even without a deterioration in credit quality, some banks may be exposed to a sudden and severe upward shift in policy rates, particularly against the backdrop of a decade of exceptionally low interest rates which encouraged banks to take on greater risks in search of yield.”

Banks are a proxy for the broader economy. While history tells us they are more than capable of finding ways to blow themselves up, more typically they have failed to manage the risks of their customers. That might be the customers who lend banks money – depositors – who may find better places to put their funds which will in turn drive up a bank’s cost of funding.

And it might be the customers to whom banks lend money, borrowers. When interest rates rise and costs mount and consumers spend less, companies and hence their financiers face challenges.

One fortunate side-effect of two decades of low interest rates, the 2008 financial crisis and Covid is that both corporates and households have behaved more prudently than was the case towards the end of the last century.

They have taken the opportunity to pay down expensive debt, build up cash buffers and invest profits wisely. Nevertheless, extremely low interest rates also encouraged more borrowing, even if for sound investments.

A debt crisis is not looming. To date, according to ratings agencies like S&P, Moody’s and Fitch, most of the stress is being felt in higher risk sectors. These higher risk organisations typically rely more on floating interest rate loans which go up as central banks raise rates. Lower risk organisations were able to lock in very low, fixed rate loans at the bottom of the rate cycle and so are quarantined for a longer period of time from high interest rate payments.

Nevertheless, higher inflation and higher rates impact these companies too and, consequentially, their financiers.

As The Economist noted in a recent feature “plenty of companies will also find themselves forced to scale back their investment ambitions”.

“From decarbonisation to automation and artificial intelligence, businesses face an expensive to-do list in the decade ahead. They may find their grand ambitions in such areas derailed by the indulgences of yesteryear. That would be bad news for more than just their investors.”

The Economist Intelligence Unit’s latest white paper, The End of Easy Money, makes several key points:

  • The latest bank failures won’t lead to a repeat of the 2008-09 financial crisis but substantial risks remain.
  • Higher interest rates will raise margins but also bad debts and bond losses. US regional banks remain vulnerable.
  • More bank failures are likely, consolidating the market further and improving competitive positions for some banks but also raising concentration risk.
  • Emerging markets will not be significantly affected by the banking ructions but face their own risks from the interplay of bank and sovereign debt.
  • Regulation and oversight will strengthen further but regulators will be keen to avoid rescuing every bank and raising moral hazard.
  • Bank lending will continue to expand but will slow in the US and particularly Europe.

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Source: EIU

Global central banks raising interest rates has a direct impact on the economy because it makes it more expensive to borrow to invest. This means the expected return on an investment must be higher to make it worthwhile to pay the extra interest – which in turn means less investments are made. The more marginal ones are dropped.

That flows onto the economy in general: less investment, lower hiring, less competition for employers, less discretionary spending on goods and services and so on.

Thus banks must keep a closer focus on issues arising with existing loans and cast a sharper eye on new lending, which again lowers investment – and slows the economy. Banks, fundamentally, are a leveraged play on the economies in which they operate. They do best when economies are doing well.

The word out of the latest reporting season, in Australia and offshore, was there is presently few concerning signs of looming credit quality issues. But we know they will come – just not to what extent.

Another BIS paper, Insights into credit loss rates, notes “credit risk was a key factor in the Great Financial Crisis and numerous other crises. Banks' overall credit losses tend to increase suddenly during a crisis from the typically low levels seen during ‘normal’ times.”

Bank bosses during the earnings season were circumspect but positive. The EIU shares that view: “For most banks we expect that the advantages of better interest margins will to some degree outweigh the costs of loan losses in the early years of our five-year forecast period, with a firmer recovery thereafter. Although more banking consolidation is likely over the next year, most banks will survive and thrive.”

Andrew Cornell is Managing Editor of bluenotes.

The views and opinions expressed in this communication are those of the author and may not necessarily state or reflect those of ANZ.

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