I operate on the basis of first seeking to understand the phenomena I am addressing through logic and recourse to the evidence base. I am very cautious in my public statements – oral or written – and always seek to consult the knowledge base. I noticed a comment in response to yesterday’s blog post – The RBA has lost the plot – monetary policy is now incomprehensible in Australia (July 6, 2022) – that insinuated that I was writing nonsense in relation to my claim that commercial banks enjoy higher interest rate environments because they can make more profit. Anyone is welcome to their opinion, but not all are of equal privilege when it comes to these issues. If you understand the basis of commercial banking and the vast amount of research on the proposition you will have no doubt in concluding that commercial banks do not like it when interest rates are low and will make more profit now that the RBA is hiking rates. To opine otherwise tells me that there is a lack of understanding about the basis of commercial banking and a disregard (perhaps ignorance) of the research literature on the topic.
What do banks do?
The evidence is clear that commercial banks are more profitable when interest rates are higher.
You might be tempted to conclude that this is because debtors pay more interest on their outstanding loans.
That conclusion is too superficial because it doesn’t really capture the basis of commercial banking which is to exploit interest rate spread in order to make profits.
The profit margin of a bank is crudely the difference between what it can get from making loans relative to the cost of acquiring the funds necessary to make those loans.
As an aside, one might be a little confused because doesn’t Modern Monetary Theory (MMT) say that loans create deposits, which suggests that banks just type numbers in relevant bank accounts and the deposits are created.
The ‘loans create deposits’ reality is in stark contradiction to the erroneous mainstream view that deposits are necessary prior to the bank making the loans and that banks loan out reserves.
If that is the case, why am I then talking here about the ‘cost of acquiring the funds necessary to make these loans’?
I discussed that issue in this blog post –
The role of bank deposits in Modern Monetary Theory (May 26, 2011).
Banks do function to take deposits, which provide them with the funds that they can then on-lend.
They certainly seek to maximise return to their shareholders. In pursuing that charter, they seek to attract credit-worthy customers to which they can loan funds to and thereby make profit.
Banks do not loan out their reserves to their customers!
The commercial banks are required to keep reserve accounts at the central bank.
These reserves are liabilities of the central bank and function to ensure the payments (or settlements) system functions smoothly.
That system relates to the millions of transactions that occur daily between banks as cheques are tendered by citizens and firms and more.
Without a coherent system of centrally-held reserves, banks could easily find themselves unable to fund another bank’s demands relating to cheques drawn on customer accounts for example.
Banks thus will have a reserve management area within their organisations to monitor on a daily basis their status and to seek ways to minimise the costs of maintaining the reserves that are necessary to ensure a smooth payments system.
When a bank originates a loan to a firm or a household it is not lending reserves.
Loans create deposits but the reserve balances have nothing to do with this – they are part of the banking system that ensure financial stability.
These loans are made independent of their reserve positions.
The reserve management division within a commercial bank is functionally separate from the loan division.
The commercial banks will seek funds to ensure they have the required reserves in the relevant accounting period.
There are multiple sources (interbank market, central bank discount window, wholesale funding markets, and deposits) and bank deposits are one way the bank can cover its payments obligations.
When a bank makes a loan it creates a bank liability which can be used by the borrower to fund spending. When spending occurs (say a cheque is written for a new car), then the adjustment appears in the reserve account the the bank that the cheque is drawn on holds with the central bank.
Does the bank’s reserve fall as a consequence? Not necessarily because it depends on other transactions.
What happens if the car dealer also banks with Bank A (the consumer’s bank)?
Then Bank A just runs a contra accounting adjustment (debit the borrower’s loan account; credit the car dealer’s cash account) and the reserve balance doesn’t change even though a settlement has taken place.
There are more complicated situations where the reserve balance of Bank A is not implicated. These relate to private wholesale payments systems which come to the settlements system (aka the “clearing house”) at the end of the day and determine a “net position” for each bank. If Bank A has more cheques overall written for it than against it then its net reserve position will be in surplus.
What does that all mean? Loans are not funded by reserves balances nor are deposits required to add to reserves before a bank can lend. This does not deny that banks still require funds in order to operate. They still need to ensure they have reserves. It just means that they do not need reserves before they lend.
Private banks still need to ‘fund’ their loan book. Banks have various sources of funds available to them, which vary in ‘cost’.
The bank is clearly trying to get access to funds which are cheaper than the rate they charge for their loans – that is maximise the spread.
So they will go to the cheapest funding source first and then tap into more expensive funding sources as the need arises. They always know that they can borrow shortfalls from the central bank at the discount window if worse comes to worse.
So the profitability of the loan desk is influenced by what they can lend at relative to the costs of the funds they ultimately have to get to satisfy settlement.
In other words, the price that the bank has to pay for deposits (one source of such funds) impact on the profitability of its lending decisions.
Domestically-sourced deposits are usually cheaper seeking funds on money markets and/or the central bank.
I will come back to that.
Just yesterday (July 6, 2022), the RBA released its latest banking indicators – The Australian Economy and Financial Markets – which help us understand this question more deeply.
Within that Chart Pack, they produce a number of Banking Indicators (starting page 30), which include the ‘Major Banks’ Net Interest Margin’ (p.30) and the ‘Funding Composition of Banks in Australia’ (p.31).
Here is the graph that tells us that Australian banks rely mostly on bank deposits to ‘fund’ their loan books.
It is clear that the commercial banks have increasingly relied on domestic deposits for their funding.
So when we talk about commercial banks managing spread we are really focusing on the difference between mortgate rates and the customer deposit rates.
The mortgate rates move, more or less, in line with the RBA’s cash rate target.
The linkages are that a rise in the cash rate target increases the borrowing cost in the interbank market (the overnight market where funds are shunted between banks to manage reserves).
The overnight rate is the foundation rate for other short-term lending rates in the money market.
Simply because if the bank can gain a higher yield safely by lending in the overnight market it will require higher rates for making loans that extend in time.
As short-term rates rise, they feed into the longer investment rates, including home mortgage rates.
When mortgage rates rise, the banks obviously enjoy higher nominal interest income flows.
But that is only one part of the story.
Given the dependence of the commercial banks on deposits, the capacity to gain higher profit margins as mortgage rates rise depends on the trajectory of deposit rates.
There are clearly a range of deposit rates depending on the fixity of the deposit. Longer term deposits attract higher returns than deposit accounts that allow instant withdrawal without penalty.
Most deposit accounts pay zero or negligible returns.
So we have a situation where the net interest margin rises and falls more or less in line with the evolution of the mortgage rates.
I am simplifying a little because the deposit rates do move a little but usually with a lag in relation to the loan rates.
Here is the graph from the RBA Chart Book that shows the Major Banks’ Net Interest Margin from 1998 to now.
And here is the RBAs Cash Rate Target (the policy rate target they set), which conditions all the other private lending rates predictably.
It is hard to argue from an eye-balling exercise that lower interest rates reduce the profit margin the commercial banks can achieve.
But I also know that eye-balling exercises are really on the beginning of analysis and so we need to understand what the research literature has found on this question.
The trajectory of the RBA policy rate interesting in itself because it discloses the knee jerk way the RBA has operated at times over this period.
In the lead up to the GFC, they started to talk up the inflation threat and pushed rates up only to meet up with the financial crisis triggered by the collapse of Lehmans in August 2007, which saw them run like crazy to lower rates.
Then after a major fiscal stimulus saved the economy from recession, the RBA became influenced by the mainstream nonsense that inflation was about to run wild again as a result of the fiscal injection and so they quickly hiked again.
The problem was that both fiscal and monetary policy danced to the mainstream tune and the economy quickly slowed in 2011-12, which saw the RBA have to acknowledge through action (not any admissions) that they had tightened too early.
And now they are making the same mistake again.
There is another aspect of commercial banking that is not very well publicised.
Commercial banks also hold fairly substantial amounts of contingency funds to safeguard against non-performing loans.
Usually, they hold these funds in fairly liquid, low-risk financial assets, such as short-term bonds and earn some interest return as a consequence.
The yields on these assets tend to move in line with general borrowing costs in the market.
So when interest rates rise generally in the economy, the banks can earn higher returns by reinvesting these contingencies at a higher rate of return.
End result: further gains in profit margins.
What does the research literature say?
On June 17, 2021, the RBA Bulletin published an interesting survey paper – Low Interest Rates and Bank Profitability – The International Experience So Far – which discussed:
… the effect that low interest rates may have on bank profits, and reviews the experience of banks in economies that have had very low interest rates for an extended period.
It is a very apposite survey of the state of knowledge on this issue.
We read that:
The core activity of most banks is lending, and they make money from this by lending at interest rates that are higher than what they pay for their funding. The net interest margin (NIM) (the ratio of net interest income to interest earning assets) is therefore a key indicator of bank profitability. If a decline in policy interest rates results in banks’ funding costs declining by less than their lending rates, then NIMs will narrow and bank profits will decline (all else being equal).
The article provides several reasons to support this view.
1. “As short-term interest rates become very low, a greater share of deposit rates may reach their effective lower bound.”
2. “If lending rates continue to decline when deposit rates have reached their lower bound, then NIMs will narrow” – which is effectively what the previous analysis above is about.
3. “The implications of the lower bound on deposit rates for banks’ funding costs depends on the amount and composition of deposit funding” – as above.
4. “The effect of low rates on banks’ NIMs also depends on how banks adjust their lending rates. ”
5. “Banks typically borrow short term (e.g. deposits) and lend long term (e.g. mortgages). As such, when yield curves flatten (and the difference between long- and short-term rates declines), banks’ NIMs narrow.”
The article also distinguishes between large and small banks, the latter which is more dependent on deposits than the former, which means ” their NIMs might compress more when interest rates decline because of the effective lower bound on deposit rates.”
Their analysis of the extensive literature on the ‘effects of low interest rates on banks’ profitability’ comes to the conclusion that:
Several papers find modest effects of lower interest rates on bank profitability … [another finds] … large effects of interest rates on the profitability of large advanced economy banks. They estimate that a 100 basis point fall in interest rates is associated with a 25 basis point fall in banks’ ROA after one year, with this effect increasing up to 40 basis points when interest rates are very low. The profitability of smaller, less diversified and more deposit-funded banks is more negatively affected by low interest rates
They also find that where banks can charge higher fees and manage lower loss provisions, the impact of falling interest rates on NIMs is smaller.
However, the research literature also finds:
A prolonged period of low rates is found by several studies to have a larger negative effect on bank profits.
On balance, they conclude that:
There is stronger evidence that bank profits decline in prolonged low interest rate environments.
The logic of banking points to the conclusion that the empirical literature has reached.
There are nuances for sure and individual variations in performance depending on certain characteristics.
But overall, banks prefer higher interest rates than lower rates because their profit margin is higher.
The qualification is that they also hope the higher rates don’t go so far as to drive the economy into recession, which then reduces the demand for loans.
That is enough for today!
(c) Copyright 2022 William Mitchell. All Rights Reserved.