Are rising interest rates really good for banks?

Reserve bank rising interest rates 2022 loans deposits
One theory for the erosion of bank share prices last week is higher interest rates will cause property prices to fall and result in an increase in bad loans.

A confusing thing happened in the wake of last week’s decision by the Reserve Bank of Australia’s board to ramp up interest rates more quickly with a 0.5% rise.

While it is accepted wisdom that rising rates are great for banks because they widen their net interest rate margins and plump up their profits, the share prices of the big four banks slumped hard in reaction to the rise.

There are a number of explanations doing the rounds on why that happened, although reading the minds of investors en masse is always a difficult task.

Is a flood of bad loans around the corner?

One theory is a really bleak one – that the rising rates will follow through to falling property prices and a serious increase in loans turning bad as heavily indebted borrowers are pushed over the edge by rising repayments.

At this stage that seems unlikely, given how far ahead on their payments many home loan borrowers are on their mortgages; although, it would not be a total surprise if bad debts started to rise.

If there is a high level of mortgagee sales amid falling house prices, that could increase bad debt provisions for the banks as well.

Has the war for deposits already started?

Another fear is that the big banks are ill prepared to fight a sudden war for deposits after the pandemic and stimulus payments combined with super low interest rates saw billions of dollars flow to the banks on very low and even no interest.

There are signs that may be changing, with investment bank Macquarie (ASX: MQG) preparing to quickly grow its retail bank deposits by launching a transaction account that pays interest of 1.5% on amounts up to $250,000 – a big rise from Macquarie’s previous rate of 0.2%.

At the moment the big four banks offer derisory rates on their transaction accounts and are able to use that massive pot of close to free money which some estimate is as big as $100 billion to write out loans at much higher rates.

Even if the rates on those loans are ratcheting up in line with the RBA rises, if the big retail banks are forced to start paying more for their deposits, that reduces their margins compared to the current situation.

Macquarie spared the worst of the share price falls

Macquarie’s disruption of the deposit market follows its moves to increase its book of home loans and helps to explain why Macquarie was spared the worst of the big share price falls that the big four suffered.

Indeed, the share price falls last week were roughly in line with the deposit bases of the banks, with Westpac (ASX: WBC) and Commonwealth Bank (ASX: CBA) falling a little harder than ANZ (ASX: ANZ) and National Australia Bank (ASX: NAB).

At the moment Macquarie is a tiny player in the transactional account space – less than 1% of the market – but offering such a competitive rate on a transaction account, could certainly force some action from the big four that currently offer a grand 0.01% interest on transaction accounts if you are very lucky and meet certain conditions.

For Macquarie, offering a higher deposit rate is like a form of advertising because it can always reduce rates down the track if the product becomes too successful.

For the other banks, competing with this sort of rate on transaction accounts is a really big headache, because the number of accounts is so much higher and the interest payments would quickly add up to serious money.

Higher term deposit rates are easier for the big banks

It is easier for the big banks to simply offer better term deposits rather than higher transaction account interest, which is something they are beginning to do in the wake of the RBA rises.

On the customer side, it is much easier to move deposits around than it is loans, so customers can be more mobile with their savings.

The other theory doing the rounds to explain the better performance by Macquarie was simply that it is much smaller in the home loan space than the big four so it was less exposed than the other banks to any growth in bad loans.

Whatever the reason for its relative outperformance, Macquarie has fired the first salvo in what could develop into a full-scale war for deposits in the banking system – something that hasn’t really happened much during the long downwards official interest rate slide since 2010.

Cash is no longer trash

In the process, individual investors will quickly need to adjust to a different environment in which the old “cash is trash” mantra may need to be modified.

As for those who hold banks shares, the idea of rising rates being good for bank profits may hold true or things really might turn out to be different this time around.

It is a judgement call about an unknowable future although no matter how high deposit rates get, it is unlikely that money in the bank will equate to the dividend payments made by the banks for some time to come.

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