Rates down, profits down? Not as such. Rates up, profits up…?

That’s the received wisdom. And, in a massive shock, it’s not always right. History tells us there is a limit to how much bank margins and profits are amplified by higher interest rates because the story is more complex.

"It follows the opposite is true as economies slow and more borrowers come under stress. There’s the old banking truism “bad loans are written in good times”. And the times have been pretty good.”

Critically, higher margins encourage more competition. Typically, higher rates are also associated with inflation and higher economic stress. Lower rates, meanwhile, haven’t always tamped bank profits as much as investors have feared (and priced in).

Now the Reserve Bank of Australia and other central banks have actually taken a proper look at this market wisdom, focussing on what happens to bank profits as interest rates fall. In short, bank profits don’t fall as much as expected because other factors come into play, notably more benign economic conditions and higher growth.

“An important offsetting factor is that lower interest rates ease the burden of making repayments on loans, allowing banks to set aside less of their profits to cover future losses in the form of provisions,” the research found.

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The central banks didn’t look at the reverse but we can reasonably draw some insight into what is likely to happen to profitability in this cycle of rising interest rates. And, just as the impact can be muted as rates fall, so too does the analysis provide some evidence the rise in profits will be too as rates rise.

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In the most recent Australian bank earnings reporting season there was indeed evidence of margin improvement in conjunction with rising interest rates. Overall, according to EY, net interest margins for the major banks rose 17 basis points from 1.71 to 1.88 per cent.

EY said this was underpinned by interest rate rises and “careful management” of mortgage versus deposit rate increases. But the firm predicted margins would tighten “as early as the second half of 2023.”

“Headwinds are rising: retail credit growth compression is creating highly competitive pricing practices, with industry commentary on pricing below the cost of capital and margins likely to tighten. Funding costs are rising, amplified by the recent dislocation in financial markets. Inflationary pressures, staff costs, technology (including cyber) and remediation costs continue to drive up operating costs,” according to EY.

Meanwhile economic conditions are tightening, there is significant disruption in global financial markets and overseas banking sectors have already seen some high-profile failures. That feeds into the cost of bank liabilities as investors who buy bank debt demand a discount for the higher risk, making funding more expensive.

There is pressure too on banks globally to pass on higher rates more quickly and visibly to deposit holders.

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Then we have the central bank research line: “An important offsetting factor is that lower interest rates ease the burden of making repayments on loans, allowing banks to set aside less (my italics) of their profits to cover future losses in the form of provisions.”

It follows the opposite is true as economies slow and more borrowers come under stress. There’s the old banking truism “bad loans are written in good times”. And the times have been pretty good.

Credit ratings agency Fitch has already flagged early signs of credit stress and while there was scant evidence of this in the March year Australian bank reports, all the banks were clear they were watching carefully.

According to Fitch’s Mortgage Market Index - Australia: The Dinkum RMBS Index 1Q23, loans on which a payment is 30 days past due, an early indicator of stress, rose by 16 basis points in the March quarter to 0.98 per cent, having bottomed in 2002. Still very low but ticking up.

The agency said it believes that may indicate borrowers are starting to face stress due to inflation and rising interest rates.

“Mortgages written between 2019 and 2021, when lenders tested serviceability using a buffer of 2.5 per cent above the borrower’s interest rate, are more susceptible to deterioration in performance, as the cash rate is now above this buffer,” Fitch said.

Business stress is also rising with the latest Australian Securities and Investment Commission data for corporate insolvencies showing ongoing deterioration with 868 businesses failing in May, the worst result since 2015.

Again, not a reason to panic but evidence that any positive margin contribution to bank profits from rising rates is likely to be dampened by a rise in provisions for bad and doubtful debts. Slower economic growth too translates into slower growth in bank lending – the banks’ assets.

The central bank research found overall the evidence showed smaller effects from falling and low policy rates on bank profitability than previously estimated.

Logic suggests the same as policy rates rise. The costs of banking will go up due to inflation and the need to more closely manage lending. Provisions to reflect the stress in the economy will rise. And to the extent there has been excess profitability in sectors of banking, those profit pools naturally encourage more intense competition.

The benefits of higher rates for bank profits are easy to overstate.

Andrew Cornell is Managing Editor at ANZ bluenotes