STUART THEOBALD: Higher rates give bankers a reason to smile

Posted in: i-Blog, Intellidex in the media on May 23, 2022

Upward-heading interest rates aren’t bad news for everyone. SA banks have finally shrugged off the Covid-19 blow to their share prices, significantly outperforming the market over the past year. Had you bought at the lows of March 2020 you would have more than doubled your money.

Why? The prospect of higher interest rates isn’t all good news for banks. On the one hand, banks’ interest margins grow but on the other hand more customers find it harder to pay as the cost of prime-linked debt rises. That can be catastrophic — indeed, the record interest rates of 1998 (reaching 25.5%) triggered such borrower distress that several banks collapsed. Given the astronomical unemployment rate that continues to head upwards, you might think that consumers particularly were highly vulnerable to higher rates. Unemployment reflects a generally weak economy that has no chance of growing average per capita incomes for years to come, so even those who are employed are under increasing pressure.

But banks are in a good position for an upward rate cycle. Covid-19 forced them into an unprecedented programme of working vulnerable customers out of their debt exposures. The result is that banking books, from a risk perspective, are in strong territory. Average loans-to-value ratios in asset-based loans are high. Commercial clients that managed to trade through Covid-19 have dialled down their financial risk and are resilient. Plus, banks put aside an unprecedented amount for bad debts in 2020. That money was expensed then but many banks have continued to hold it on the balance sheet, ready to write it back into income and help profits.

The 125 basis points of rate increases we’ve had, with 50 of those this week, help banks’ bottom lines. Interest margins have been creeping up since the rate cycle began, with the industry sporting  a healthy 3.86% in March (the latest data available, though still below the pre-Covid levels of 3.89%). Margins had been growing anyway, driven largely by savings on banks’ cost of funding. Depositors have been putting more money into call accounts relative to fixed deposits, cautious about liquidity in these uncertain times. That means banks have had to pay less interest.

But short-term deposit accounts are often not prime linked, if they pay any interest at all. So banks’ “endowment” — the amount of funding they hold from shareholders, depositors and others who don’t have to be paid interest — is currently at very healthy levels. One indicator of that is the amount of overnight deposits they are holding for customers — it is now at 22% of their balance sheets, a record as far as I can tell, meaning banks are less sensitive to interest rate hikes on their cost of funding than ever before.

So the improvements on interest earned from banks’ assets are now adding more to profit ratios. This has been helped a little by a cyclical shift during Covid-19 into asset-based lending. Banks switched out of unsecured lending and into lower-risk lending like home loans. Those are more sensitive to prime, so margins will be more responsive to the higher interest rates.

Over the longer term, banks’ earnings growth drivers tend to cycle between non-interest revenue (think fees and insurance premiums) and interest earnings. The inflation outlook is likely to put pressure on fees, but the interest margins will more than make up for it. Happy days for bankers.

But the problem banks are going to face is a stubborn refusal of the economy to grow. While they may be more profitable, the overall economic outlook means it is going to be tougher to find new business to do. That will be the binding constraint on future profitability — there is only so much that bigger margins on a finite book can do for you. Eventually you need the book itself to grow.

For now, bankers will be content that their share options are well in the money. Shareholders will want to see evidence of bankers nevertheless looking for new ways to grow their businesses. There are some opportunities to do that: one obvious one is financing new electricity generation plants, which will kick off once bureaucratic obstacles are cleared for companies to generate for themselves.

But the critical question is when the corporate sector more widely is going to start investing. It is only then that the appetite for debt will pick up at a macro level. That will require better business confidence as well as a higher level of capacity utilisation across the economy. In other words, companies need to believe that people want to buy their products, and that their existing capacity isn’t enough to meet that demand. Until electricity is sorted out, as well as wider confidence in reforms being delivered to how the economy works, I don’t see that happening.

But bankers haven’t had much to cheer about for some time. Watching those margins tick up will have put a smile on many of those faces, as well as their shareholders’. Let them be content even though the deeper growth constraints remain.

• Theobald is chair of research-led consulting company Intellidex. This article first appeared in Business Day.

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