Impact of European Monetary Policy on Bank Margins in the US
SEE LAST PAGE OF THIS REPORT Howard Mason
FOR IMPORTANT DISCLOSURES 203.901.1635
June 5, 2014
Impact of European Monetary Policy on Bank Margins in the US
- European monetary policy matters to bank net interest margins in the US because the risk of disinflation has collapsed European bond yields (to 1.6% on the 10-year from 2.2% at end-2013) dragging down US Treasury yields (to 2.6% on the 10-year from 3%). US fundamentals, including likely 2.5%+ GDP growth over the next 12-months and improving labor markets, are consistent with mid-cycle recovery and higher rates, and this is reflected in the forward markets.
- The rate cuts and liquidity measures announced by the ECB today, along with aggressive remarks from Mr. Draghi’s (“Are we finished? The answer is no”), will reduce the disinflation premium in Eurozone, and hence US, bonds by increasing confidence in the downwardly-revised ECB forecast for 2014 growth in GDP of 1%. The ECB added that, should inflation (forecast at 0.7% for 2015 vs. the policy target of near 2%) not respond to today’s measures, it would shift to quantitative easing.
- Of course, US bank margins are affected by interbank, rather than Treasury, rates and specifically by the 3-year swap (3YS) rate given the average duration of bank balance sheets. The forward markets are pricing in a 3YS rate of 2.6% for mid-2015, up 20 basis points in the last week and vs. 0.9% today. With 6-month Libor (6ML) indicated at 1.6% vs. 0.3% today, bank margins will likely have a meaningful tailwind from both rising rates and a steeper curve.
- As shown in the Exhibit below, our model suggests a margin-benefit in 2015 vs. 2014 of 80 basis points (50 from increased slope and 30 from the impact of higher short rates on the return from liability, and specifically, deposit franchises).
- Some rate-benefit will be seen in bank margins in 2014 but offset by pricing pressures on loans. Since 2012Q4, for example, the increase in slope (3YS less 6ML) has added 60 basis points to bank margins but been overwhelmed by a 70 basis point decline in asset spreads; as a result, the overall margin aggregated across US commercial banks has declined to 3.1% from 3.3%. That said, bankers are now reporting a stabilization of loan pricing, and we expect rate benefits to begin to flow through to reported margins this quarter and beyond.
Exhibit 1: Components of Bank Net Interest Margins Aggregated across US Commercial Banks
“We need a more appropriate monetary policy because the level of the euro is too high. We need a major change that makes our monetary policy a tool for growth and job creation.” Manuel Valls, Prime Minister of France, May 3rd, 2014
Today’s announcement from the European Central Bank (ECB) that it is reducing the rate for banks on its overnight deposit facility to negative 0.1% from zero is not going to spur lending; the policy target is the exchange rate as the Euro, now at $1.36, has strengthened 10% against the dollar over the last year crimping exports and hence growth. The Central Bank hopes to weaken the euro and reduce the risk of disinflation by boosting exports, and hence growth, and increasing import prices.
European monetary policy matters to bank investors in the US since it is impacting US yield curves, and hence net interest margins. The prospect of disinflation has collapsed Eurozone central-government bond yields (to 1.6% on the 10-year from 2.2% at end-2013) dragging down US Treasury yields (to 2.6% on the 10-year from 3%). The rate cuts and liquidity measures announced by the ECB, along with Mr. Draghi’s aggressive commentary, will increase confidence in the reset ECB forecast for 1% growth in Eurozone GDP and erode the disinflation-premium in Eurozone, and hence also Treasury, bonds
This is consistent with the view from the forward markets which are signaling a meaningful back-up in long rates for 2015. For example, the forward markets indicate an increase in the 3-year swap rate to 2.6% from 1% today so that the curve will become more positively sloped even as short rates increase; indications are for 6-month Libor to increase to 1.6% from 0.3% today. These are key rates for bank margins as the value of deposit franchises increases with the rising cost of short-term interbank funds; and the return from the core asset-liability management or ALM gap (as banks fund short and lend long) rises with the slope out to about 3 years (equal to the average duration of bank balance sheets).
Forecasting Net Interest Margins for US Banks
We quantify our view by unbundling bank net interest margins into three components, and linking these components to the forward markets. The foundational notion is that if a bank had no deposit franchise and no loan franchise, it would borrow and lend in the interbank markets so that, under reasonable duration assumptions, its net interest margin would equal the slope between the 3-year swap rate (3YS) and 6-month Libor (6ML).
In practice, of course, banks have deposit franchises to improve on funding rates available in the interbank markets and asset franchises to improve on lending rates available in the interbank markets. We capture the benefit through a “liability spread” which is equal to the difference between 6ML and a bank’s actual cost of funds; and an “earning asset spread” which is equal to the difference between a bank’s actual yield on earning assets and 3YS.
Exhibit 1 reports the results of this margin model aggregated across all US commercial banks reporting to the FDIC. It bears out a remark by WFC CEO John Stumpf on May 20th that the deposit franchise was “significantly under-appreciated”; the liability spread is currently negative and has been since the Fed’s lowered the target fed funds rate to 0-0.25% in December 2008; zero-interest rate policy (ZIRP) is not good for the profitability of bank deposit franchises. More recently, over the last 3 years, the margin contribution from the slope of the curve was eroded by quantitative easing which has driven 3YS down from 5% in 2007 to below 1% today and the spread over 6ML to negative 10 basis point in 2012 from 90 basis point in 2012; in 2013, there was some recovery with the slope rising to 30 basis points as short rates fell while long rates were stable.
Exhibit 1: Components of Bank Net Interest Margins
We are in an unusual environment when neither liability franchises nor core ALM management generate a meaningful contribution to bank net interest margins; typically, declining short rates reduce liability spreads but increase the slope (as in 2002, for example) and rising short rates increase liability spreads but reduce slope (as in 2006, for example). Over the next two years, the forward markets are indicating a meaningful improvement in bank margins with rising short rates (as ZIRP comes to an end) and increasing slope (with tapering of Fed mortgage purchases in the quantitative easing program).
Competition for Loans
A key question is whether the margin benefit from an improving rate environment will be offset by pricing pressure on loans. Since 2012Q4, for example, the benefit of a 60 basis point increase in slope has been entirely given back by loan pricing pressures. It is not just that banks cannot pass through increases in their cost of funds; rather, loan yields have declined so the earning asset spread has declined by 70 basis points vs. a 40 basis point increase in the 3-year swap rate. The result is that aggregates net interest margins have barely budged over the period (see Exhibit 2).
Exhibit 2: Quarterly Trends in Net Interest Margin Components
Recently, however, loan officers are commenting that pricing pressures are easing (although banks continue to compete by loosening other terms) with pricing stable on C&I loans since 2013Q4 despite the decline in Treasury yields. For now, our model does not corroborate this (and, in fact, indicates that loan spreads compressed quite sharply in the first quarter), but we believe the margin benefit of an improving rate environment will begin to show through in reported results beginning this quarter.
- The accompanying liquidity measures and, in particular, allowing banks to finance up to 7% of their euro-area non-financial private sector loans excluding mortgages. These targeted long-term refinancing options are TLTRO could amount to EUR400bn maturing in September 2018.