Bank's Net Interest Margins Squeezed

Originally published by Rivkin Securities

With National Australia Bank Ltd (AX:NAB) releasing its financial report for the December quarter, it is a good time to talk about some of the challenges facing banks at the moment. NAB reported stable earnings relative to the prior corresponding period although revenue increased by 1%. The net interest margin – the difference between interest charged to borrowers and interest paid to depositors – was also stable. Net interest margins, and therefore profitability, have been under pressure for all of the banks for some time now as a result of low interest rates. Chart 1 shows the trend in net interest margin for each of the big four banks since 2011.

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Chart 1 : Net Interest Margins for the Big 4 Banks

The problem for NAB is that its net interest margin is the lowest of the four and is over 10 basis points lower than the next worst, ANZ Banking Group (AX:ANZ). Nevertheless, NAB appears to have arrested the decline for now and the report of a stable net interest margin for the December quarter is encouraging.

Generally speaking, higher interest rates are beneficial for banks as it allows them to earn a larger interest margin. With the Reserve Bank of Australia currently maintaining the cash rate at 1.5%, interest rates in Australia have never been so low. Although it is unclear if this will prove to be the bottom of the cycle, few would disagree that rates will have to rise sometime in the future. In fact, longer term interest rates have already started increasing from lows reached last year. The yield on government bonds is usually used as the benchmark for longer term rates and for mortgagees with 10, 20 or 30 year mortgages, long term yields are the relevant comparison. The yield on the Australia 10-Year bond is currently 2.77%, significantly higher than the 1.82% reached in August 2016. Although these bond yields don’t directly affect the cost of funding for banks, they will push long term interest rates up economy wide and therefore basic economics suggests that these increases will eventually be passed on to consumers via higher mortgage rates.

In fact, increases in mortgage rates have already started happening, with AMP Ltd (AX:AMP) and Bankwest increasing variable rates in the last couple of days and most of the other banks increased their rates late last year. These rate rises aren’t only caused by rising bond yields but also by increased regulatory pressure. Central banks and relevant regulatory bodies globally have been working together for several years now to produce new capital requirements for banks that are designed to reduce the risk of another financial crisis. The effect of these regulations, however, is that banks must hold on to more capital relative to the amount of lending which directly impacts their ability to generate profits.

This requirement to hold more high quality equity capital is one of the main drivers of the large quantity of hybrid issues by the banks. NAB specifically mentions that it is considering another hybrid issue for 2017 to improve its capital position. This comes as the bank announced in its quarterly report that its common equity Tier 1 (CET1) ratio fell by 0.3% for the quarter to 9.5%. Although this is still well within the target range of 8.75-9.25%, the magnitude of the fall may be a concern for the bank.

Although conditions for the banks are challenging, all four are managing well with their share prices having risen since November last year. Rivkin maintains a portfolio of hybrid securities that contains issues from several banks and pays a steady stream of distribution income. The Rivkin Investment team will evaluate any new issues that come out this year and recommend for investment any that fit our criteria.