Higher margins outweigh loan losses when rates rise: BIS
The positive impact for banks of higher margins when interest rates rise will, in most cases, more than offset the negative impact of higher loan loss provisions, according to a new study.The Bank for International Settlements has released a research paper on the influence of monetary policy on bank profitability, which it says is an under-researched topic.The BIS was motivated to do the research, in part, because of growing concerns in recent years that the benefits of prolonged monetary accommodation post-financial crisis might be declining due to its negative side effects. One of those side effects is the impact on bank profitability.The paper's starting point is that monetary policy is not the only influence on the interest rate structure but it has a major impact. Central banks control the short-term rate through the policy rate. They have an indirect influence on the yield curve, through their impact on market participants' expectations about the future policy rate path."High real interest rates are associated with higher interest margins and profitability," it said.This is because bank deposits are typically priced as a markdown on market rates. If the markdown gets smaller as the interest rate declines, then a shift to monetary policy tightening would increase interest income.However, there is also a positive correlation between bank loss provisions and short-term interest rates."Higher rates boost the default probability of the existing stock of variable rate loans by increasing debt service burdens," the report said.This sensitivity should be especially high when rates are rising from a low base. "This is because low rates prevail following financial downturns, when customers' balance sheets are in bad shape," the report said. Overall, "the positive impact of the interest rate structure on net interest income dominates the negative one on loan loss provisions."The report is less clear about the impact of monetary policy on non-interest income. It said higher rates could generate losses on banks' securities portfolios.