This is turning out to be the year when rapidly rising interest rates and their impact on the real economy and the global financial system have come into sharper focus for banks and regulators.
In March, the collapse of three regional banks in the US was attributed to a range of factors, including aggressive hikes in interest rates and certain banks’ inability to adequately manage their interest rate exposures.
But rising interest rates have not only caused banking failures. They have also been a boon for banks’ balance sheets.
The four large UK banks showed significant improvement in profitability in the first quarter of this year, boosted by strong growth in net interest income (NII). In the first quarter of this year, the aggregate NII of the UK banks grew by a healthy 39% year on year, according to DBRS Morningstar.
Banks are earning higher interest rates on mortgages and new loans, and deposits they hold at the central bank. But in the midst of a cost of living crisis, the income banks are pocketing due to higher interest rates has attracted the scrutiny of governments and regulators, with some UK government ministers accusing banks of profiteering and not passing on higher rates to savers.
Banks slow to pass on higher rates to savers
“So far, we haven’t seen UK banks paying higher rates on deposits,” says Maria Rivas, senior vice-president, global financial institutions at DBRS Morningstar, adding that it is exactly the same situation in Europe. “It will be driven by competition. Depositors who are paying higher rates on their mortgage, will likely demand higher rates on their deposits.”
In a recent webinar on European banks’ liquidity, Nicolas Charnay, senior director and European financial institutions sector lead at S&P Global Ratings, stated that in the EU, repricing of deposits was relatively limited in the past year.
Deposits are 56% of funding for EU banks, but Mr Charnay said the share of policy rate increases passed through to depositors was relatively low compared with historical levels. “The deposit betas on average in the Europe area were around 20% between July and April. The last increase in policy rates by the European Central Bank back in 2006, [deposit] betas were almost double back then.”
While there is some evidence of migration towards fixed-term deposits, which offer higher returns, Mr Charnay said there was not a substantial move overall in the EU. “[The] key reason is the availability of deposits in the system. Banks that have a lot of access to deposits don’t see the need to pay [higher levels of interest] to attract deposits. If we compare that with the situation in 2006 we had much higher loan-to-deposit ratios.”
More competition needed
Antonio Fatas, professor of economics at Insead, says the reality is that most of us have very sticky relationships with our bank. “Of course, as time passes, people might get mad and say, look, this is not right. I’m going to go somewhere else,” he says.
In order for banks to do the right thing by their customers and pass on higher interest rates, Mr Fatas believes there needs to be more competition. “But it’s a complex question because you don’t want to make the banking system too competitive and unstable. Sometimes more competition means more banks will fail. And we understand that creates a systemic risk that we don’t always know how to deal with. So there’s a very careful trade-off between making the system more competitive, which it should be, and adding an element of uncertainty and volatility and the possibility of a banking crisis.”
At its July Financial Stability press conference, Bank of England (BoE) governor Andrew Bailey said it had seen more banks pass on of higher interest rates in fixed-term deposits than in sight deposits. “There is a reason for that from the point of view of liquidity management of banks,” he explained. “Not surprising we’ve seen customers switch from sight to fixed deposits.”
Mr Bailey added that there is a more structural rebalancing of rates going on as the UK moves away from zero interest rates. “Before the financial crisis it was pretty typical for the average rate banks paid on savings to be just below our official rate. We’re seeing the re-establishment of the old order. It’s important that rates get passed through and that we have competition in the banking system that encourages banks to compete.”
According to BoE data from May, households, on net, withdrew a record £4.6bn from banks and building societies, the highest level of household withdrawals since records began in October 1997. Net withdrawals of interest-bearing sight deposits increased significantly from £5.4bn in April to £11.4bn in May, while non-interest-bearing sight deposits saw their seventh consecutive month of net withdrawals at £3.3bn in the same month.
However, Will Edwards, who covers UK banks for S&P Global Ratings, says the balance sheet effects of deposit outflows are manageable for banks. “As deposits move around the system banks still have significant liquidity headroom,” he says.
Banks under pressure
Intervention by governments is also affecting deposit repricing. For example, in France, the government applied pressure on banks to reprice rates on regulated accounts such as the Livret A savings scheme. In the US, the flight to money market funds is driving some deposit repricing for banks.
In the UK, the threat of government and regulatory intervention on savings rates looms large for banks. On July 6, the UK’s Financial Conduct Authority (FCA) held a meeting with the UK’s largest banks and building society to discuss savings rates. Referring to the new Consumer Duty regulations, which come into force at the end of July, the FCA said it had started to see some positive action by banks and building societies to improve their rates, and to ensure their customers are benefiting from better value products. “We now want to see that progress accelerate,” the FCA stated.
On 28 June, UK chancellor Jeremy Hunt chaired a roundtable with CEOs from leading regulatory agencies, including the Competition and Markets Authority and the FCA, to agree on an action plan to ensure customers are treated fairly. At the end of July, the FCA will publish a report outlining how the savings market is helping savers to benefit from higher interest rates. The action plan also requires the largest banks and building societies “to explain the pace and extent of their pass-through of interest rates, and how they are proactively supporting savers to switch to high-interest-rate products”.
Ms Rivas of DBRS Morningstar says higher pass-through rates on deposits will be a negative driver on bank profitability in 2023, but banks will still benefit on the asset side from rate rises. ”For the next few quarters, the key uncertainty remains the impact of higher interest rates, inflation and elevated cost of living on asset quality and cost of risk,” she says.
Greater credit losses coming
Given the challenging macroeconomic environment, rating analysts expect to see higher levels of loan losses to start materialising in banks’ loan portfolios, with unsecured retail, specialist commercial and smaller business lending expected to be the most at risk.
“We are starting to see this in loans classified as Stage 2 loans on banks’ balance sheets. This staging signals assets that are in early arrears or that banks believe are likely to fall into arrears, and so the fact that banks are putting more loans into Stage 2 shows their anticipation of stress,” says Mr Edwards from S&P Global Ratings. “For example, Nationwide now has around £36bn of its £202bn mortgage lending book in Stage 2, even though arrears remain low.”
Huseyin Sevinc, a senior director in the EMEA banks team at Fitch Ratings, says it saw a buildup of expected credit losses by UK banks in the third quarter of last year as the economic outlook started to weaken. “This was driven by expectations that a recession, high inflation, rising unemployment and house price falls will result in higher credit losses in 2023, rather than by actual increases in impaired loans,” he explains.
For a loan to be impaired it needs to be three months in arrears, so rising loan losses will take time to filter through, says Ms Rivas. “We will probably start to see a trend of deterioration in 2023, but my guess is that we will see more trouble in 2024. However, a key driver of the asset quality deterioration is economic developments, including higher unemployment levels, and how GDP performs.”
The negative impact on borrowers of higher-for-longer interest rates, which is expected to contribute to higher credit losses for banks, saw S&P Global Ratings increase its latest credit loss forecasts for 2024, which it expects will rise to approximately $814bn, 24% higher than its previous forecast of $656bn.
For the 83 banking systems it covers, Fitch says credit losses could total more than $1.5tn over the two years to the end of 2024, which represents an annual rise in losses of $105bn (16%) in 2023, and a more modest $42bn (5%) in 2024.
More than half of the $1.5tn in losses – about $847bn – is expected to come from China’s banking system, says S&P Global Ratings, reflecting its sheer size. Losses in North America, Western Europe, and the Asia-Pacific region (excluding China) amount to approximately $517bn, or one-third of the global total, evenly spread across the regions.
S&P also expects subdued loan growth across much of the world for 2023 and into 2024, with the downside risks to its forecast remaining significant. “In particular, weaker economic performances could result in higher corporate insolvencies, where leverage is extremely high, fuelling higher credit losses,” says S&P Global Ratings credit analyst Osman Sattar. “Falling residential and commercial property prices across much of the world could further expose banks to losses,” he added.
There are already signs that the strong NII growth banks saw in 2022 is coming under pressure. According to S&P Global Market Intelligence data, the pace of growth in NII slowed in the first three months of 2023. Net interest margins are expected to top out in late 2023 or early 2024 and then tighten as credit growth stagnates and competition for deposits intensifies.
UK banks “are resilient”
So, how resilient are banks to withstand these challenging market conditions?
The results of the BoE’s 2022/23 annual cyclical scenario stress test suggest that the major UK banks would be resilient to a severe stress scenario.
The BoE said the stress test scenario was more severe than the 2007–08 global financial crisis, and “substantially more severe” than the current macroeconomic outlook, because it combined increasing interest rates (the bank rate was assumed to rise from below 1% to 6%, compared with the 4% used in previous tests) with considerably higher inflation than recent peaks, along with deep and simultaneous recessions in the UK and global economies with materially higher unemployment.
“The UK banking system has the capacity to support households and businesses through a period of higher interest rates,” said Mr Bailey. “The resiliency of the banking system is not a constraint on banks managing their net interest margin and the rates they pay to savers and mortgages. That wasn’t alway the case in the past.”
But given the collapse of smaller regional banks in the US earlier this year, the BoE is working with HM Treasury to ensure that there are resolution options for small banks to give depositors continuity of access.
Mr Bailey said elements of the global financial system such as riskier corporate borrowing (leveraged lending) and commercial real estate remain vulnerable.
It may take time for the full impact of rising interest rates to start filtering through to the real economy and banks’ loan books. But one thing is certain: the repercussions are far from over.
