Wednesday, May 4, 2016

3/5/16: Banks Have Way Bigger Problems Than Low Interest Rates

Almost not a day goes by without someone, somewhere in the media whingeing about the huge toll low interest rates take on banks profitability. This is pure red herring put forward by banks' analysts that have an intrinsic interest in sugar-coating the reality of the banking sector failure to adapt to post-GFC environment.

In its international banking sector review for 2015, McKinsey & Company research (see here: briefly tackled the pesky issue of banking sector profit margins and their sensitivities to current interest rates environments.

Here’s what McKinsey had to say on interest rates ‘normalisation’ and its impact on banks’ margins:

Source: McKinsey & Co

Do note that 2.3 bps Return on Equity uplift in the case of Eurozone banks is in basis points, on top of 2014 ROE for Eurozone banks of 3.2%. Which would push ROE to 5.5% range.

Here are the conclusions: “In our analysis, however, even if rates rise broadly – a big if – banks will not do as well as many expect; margins will not jump back to previous levels. Much of the benefit will get competed away, and risk costs will likely increase, especially in economies where the recovery is still fragile. …On average, banks in the Eurozone and the U.S. would see jumps in ROE of about 2 percentage points, but these gains would still not lift returns above COE (Cost of Equity). And as the “taper tantrum” of 2013 showed, the reaction of markets to a change in central bank policy is far from clear; unforeseen problems could easily overshadow any gains from a rate rise.”

So to sum this up:

1) Let’s stop whingeing about poor banks squeezed by low interest rates: these banks face zero or even negative cost of funding which subsidies their unsustainable business model; the same banks are also benefiting from a massive monetary subsidy (low interest rates reduce loans defaults and prolong cash extraction period for the banks prior to loan default materialisation);
2) Even if interest rates are ‘normalised’, the banks won’t be able to cover the cost of equity through their normal operations; and
3) The real reason banks are bleeding profits is because they are incapable of reforming their business models and product offers and are, as the result, suffering from challengers taking chunks out of traditional banks’ most profitable business strategies.

But, more on this in my forthcoming article for the International Banker.

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