As interest rates are cut, borrowers will cheer but those living off interest income are watching their income rapidly dwindle, as rates approaching zero.
Those living off interest income have a choice: maintain their asset allocation and dip into their principal for the income they need or take on risk to achieve a higher yield?
Many may look to high yielding shares such as the banks and Telstra. Should they?
As is so often the answer…. It depends.
Let’s have a look at the banks today and the environment they are operating in:
Banks are sitting on around $2.2tn in deposits (source: APRA monthly bank statistics June 2019);
As interest rates are cut there is political pressure to pass on as much as possible to borrowers but there is less scope to pass this on to deposit holders and it is expected to cut into banks’ profits.
This impacts their net interest margin i.e. the difference between what the banks charge for lending and their cost of funding.
This points to banks growth in earnings being constrained.
What do falling cash rates mean for banks?
The last two rate cuts amount to 0.5%. The banks carefully considered how to maintain their net interest margin and so the cuts to loans varied whether you were a business, owner occupier mortgage or borrowing for investment. It may also have differed if your loan was principal and interest or interest only.
Why would it vary? It would vary for a number of reasons, some business specific reflecting the makeup of their lending book, some not business specific such as political sentiment. The objective being to minimise any impact on their net interest margin.
Looking anecdotally at the owner occupier rate, the cut has been in the order of 0.44%, less than the RBA rate cuts.
The cut to deposit rates has been similar.
Consider now that over 35% of deposits are already paying less than 1%pa (source: Mozo). Consider also a saturated home loan market, with intense competition for new loans. Taking a quick look at Canstar, the comparison rate for one of the lowest cost loans is just 3.08%pa whilst the big banks are ranging from 3.59%pa to 5.33%pa. The big banks are quite a bit more expensive than the smaller players and even against each other, the variation in rates is enormous.
If the RBA were to cut further, no doubt lenders would pass some on, but you should expect less pass through as a borrower. A very important source of funding for banks is deposits and they can’t really reduce interest to less than zero. They are unlikely to get this low for fear of seeing their deposit base significantly reduce.
Let’s have a look at how important:
With 60% of funding from domestic deposits, banks can hardly afford to scare money away with zero interest rates. They certainly can’t start charging to put money on deposits (or could they?).
And deposits are not growing but rather they are stagnating, further challenging the funding costs for banks as they either head offshore or borrow from the banker to the banks i.e. the RBA.
So, let’s sum up the challenges facing banks:
official cash rates are at record lows and the RBA has openly said they will continue to cut if conditions do not improve;
Shrinking net interest margins, compounded by every rate cut
Collapse in fee income, especially post royal commission
Remediation costs post royal commission
Tighter lending requirements post the royal commission
Strong lending competition, including from non-regulated lenders
Low deposit yields driving yield hungry investors into other assets
Pressure to have unquestionably strong balance sheets, forcing them to keep high levels of dormant capital on the balance sheet
Open banking – making loans more portable
The profit growth outlook for banks looks very challenging. One might be forgiven for thinking the best outcome is maintaining current levels of profit.
So, what about that Net Interest Margin, perhaps the best measure of the direction in bank profitability?
It’s been falling for 20 years. The difference now is that there are no new apparent avenues of revenue from which to grow profit.
Recently there has been some relief for banks with a change to the interest rate floor used to assess loan affordability reduced from 7% to 2.5% above the advertised rate for the loan. This may see the volume of loans increase not necessarily the net interest margin.
However, the stringency applied to assessing living expenses remains high with the prevailing assumption being that a prospective borrower’s spending habits will remain the same once they take on a home loan. (Could this see widespread constraint in household expenditure in the pursuit of establishing a savings history, further impacting economic activity?)
What levers can the banks pull? They can break from the RBA rate signals i.e. move their rates independently of the RBA. This is not ground-breaking, but it becomes increasingly challenging with more lenders in the market. Also, cost cutting measures can be undertaken to protect margin.
In fairness, the banks have done okay looking after shareholders:
Can the banks navigate their way back to growing profits and dividends?
Maybe. If low rates see a surge in real estate activity and a net increase in lending, perhaps lending volumes will maintain bank profitability. But will it see earnings growth? If Australian’s receiving a tax cut this financial year spend rather than save, businesses may experience some unexpected growth.
If house prices stabilise and perhaps increase, consumer confidence may return. If consumer confidence returns and activity picks up, inflation may pick up and an upswing in the interest rate cycle may be on the horizon but at this stage it looks like lower for longer.
If you’re a retiree, you may be of the view that you are more concerned about the dividend than the share price. Bad news: banks can cut their dividends. They did so after the GFC. And it doesn’t have to be a GFC to see the banks cut rates – like any company, they will do so if profitability is threatened to maintain a strong balance sheet. NAB cut their most recent interim dividend by 16 cents per share. That’s a drop in an investor’s income of 16%.
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