In the 15 years after the global financial crisis, the MSCI World Banks Index rose by 14%, a small fraction of the 195% in returns global stock indexes gained during the period. The difference in performance can be explained in part by the tightened regulations restricting banks’ ability to leverage their balance sheets to boost the rates of return for their shareholders. Combined with an increase in labour costs and capital reserves required to meet compliance standards, banks have had to raise their expenses, which impinged on their profitability. Falling interest rates worldwide have also been a factor that most would attribute to have impacted banks’ net interest incomes.
But would banks benefit from an increase in interest rates aimed at stamping out inflation? Before we get to the bottom of this, we think it makes sense to unpack the relationship between net interest rate spread and interest rate. According to a research report authored by economists from the Bank for International Settlements and the US Federal Reserve surveying more than 3,400 banks in 47 countries globally, a bank’s net interest rate spread will typically decrease alongside a drop in short-term interest rate (3-month Treasury bond yields). The narrowing effect on banks’ net interest rate spreads is also more evident in countries with lower interest rates than those with higher rates such that, in the former, banks’ net interest rate spreads will drop by as much as 17bp when the short-term interest rate is lowered by 1%. In the latter, however, a drop in short-term interest rate of the same degree will only reduce banks’ net interest rate spreads by 9bp. Banks in areas with higher interest rates should also have relatively higher returns on assets.
Clearly, in times of economic growth and rising interest rates, bank stocks generally make a prime investment opportunity: An increase in interest rates will widen banks’ net interest rate spreads and returns on assets, while economic growth will also stimulate demand for loans and reduce risks of bad debt – both conducive to the profitability of banks.
Having said that, despite the Fed hiking rates in the past few months, the S&P Bank ETF underperformed the broad market. This is contributed by economic uncertainties emerging across China, the US and Europe: The US, for one, saw its Q1 GDP drop by 1.4% YoY; Europe has also been confronted with recessionary pressure due to elevated natural gas prices resulting from the Russia-Ukraine conflicts; lastly, China’s battle against the pandemic will likely lead to a slowdown in consumption and export, potentially curbing its economic growth. With one of the two requisites missing, the time is perhaps yet to be ripe for banks’ outperformance.
What about the net interest rate spread in China, then? It certainly will require more than one round of regression analysis to untangle the correlation between net interest rate spreads and interest rates in China. The marketization of its interest rates only approached the final stages of completion in 2015, before which the net interest rate spreads were largely in the hands of the government, making deciphering the spread’s correlation with the rise and fall of interest rates difficult.
Only six years’ worth of data since 2016 is currently available – a dataset far from sufficiently populated from which to extract any concrete conclusion. However, when we compared China’s 3-month Treasury bond yields with the net interest rate spreads of China Construction Bank (CCB) and China Merchants Bank (CMB), some might notice what appeared to be a positive correlation where rises in interest rates led to the widening of net interest rate spreads. But such an observation would go against our analysis of changes in interest incomes and interest rates found in the annual reports of domestic banks in China: the numbers provided respectively in the 2021 annual reports of both CCB and CMB point to a decline in their net interest incomes when interest rates rose.
For investors on the prowl for specific banks that stand to benefit from interest rate rises, we think those in Hong Kong and overseas markets should be given higher priority over domestic Chinese banks. So far, the policy direction in China looks to be skewed towards lowering the interest rate, rather than increasing it; still, another uncertainty lies in exactly how a rise in interest rate, unlikely as it is, will affect the net interest rate spreads across domestic banks.
Disclaimer
This document is based on management forecasts and reflects prevailing conditions and our views as of this date, all of which are accordingly subject to change. In preparing this document, we have relied upon and assumed without independent verification, the accuracy and completeness of all information available from public sources. All opinions or estimates contained in this document are entirely Zeal Asset Management Limited’s judgment as of the date of this document and are subject to change without notice.
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