What to expect from bank net interest margins

What to expect from bank net interest margins

In this week’s video insight Stuart discusses the performance turnaround from the major banks, which is due to a change in the market’s outlook for net interest margins on the back of an expectation of rising rates.

 Transcript

Stuart Jackson:

The performance of the major bank stocks has improved over the last couple of months after a poor December quarter. The source of the turnaround is primarily a change in the market’s outlook for net interest margins on the back of an expectation that the Reserve Bank of Australia (RBA) will begin raising its overnight rate soon after the election.

Net interest margins have been under pressure as a result of the ultra-low official overnight rate set by the RBA as an emergency response to the COVID-19 pandemic. This impacts net interest margins in two ways. First, it reduces the banks’ funding advantage provided by their deposit bases relative to wholesale market-funded non-bank lenders.

Around two-thirds of the funding of the major bank interest-bearing assets comes from deposits. The interest rate paid on deposits is generally lower than the rate paid on funds sourced from wholesale markets. However, there is a zero rate floor on the interest rate banks can pay on deposits as it would be difficult for banks to pay a negative rate to depositors.

With the benchmark RBA rate falling to 0.1 per cent, the average cost of deposits has increased relative to the benchmark one-month bank bill swap rate used by wholesale markets to price the debt that funds non-bank competitor loan books. This impacts banks with a larger proportion of their deposit bases coming from low-rate transaction accounts relative to term deposits, as they hit the zero rate floor much earlier in the RBA rate cut cycle.

While the average funding cost of non-banks is still higher than the funding cost for the major banks, the gap has narrowed materially over the last two years, making the non-banks far more competitive.

This will begin to reverse once the Reserve Bank begins lifting official rates in the middle of this year.

Of course, higher rates will likely have an offsetting negative impact on the demand for credit and potentially loan losses in the medium term.

The other impact of lower rates comes from the return generated from the liquids portfolio held as part of a bank’s prudential requirements. The liquid assets are generally invested in fixed interest assets like 3-year bonds. As interest rates fall, the returns generated on these securities also tends to reduce. The Reserve Bank’s policy of targeting a 0.1 per cent yield on 3-year bonds in response to the pandemic exacerbated this impact in 2021.

The banks run a rolling hedge book on their liquids portfolio to smooth the impact of changes in bond yields over a 3 to 5 year period. As a result, material changes in bond yields take years to fully flow through to the return generated from the liquids portfolio and reported as income by the banks, impacting net interest margins more slowly but over a longer period of time.

The returns generated from liquid assets has been falling gradually over the last few years, putting downward pressure on reported net interest margins. However, with intermediate bond yield jumping materially from October last year, the rolling average rate of return is likely to stabilise in CY22 before beginning to rise, removing this source of downward pressure on net interest margins and eventually providing a tailwind toward the end of this year.

Both of these factors appear to be bottoming at the moment and are likely to start to reverse in the second half of the calendar year. This would see net interest margins turn from a drag to driver of earnings growth for the major banks.

The Montgomery Funds owns shares in Commonwealth Bank and National Australia Bank. This video was prepared 14 April 2022 with the information we have today, and our view may change. It does not constitute formal advice or professional investment advice. If you wish to trade these companies you should seek financial advice.