Even the Banks Are Afraid of Higher Interest Rates

Even the Banks Are Afraid of Higher Interest Rates

Last weekend we looked into the return of the two-speed economy. But Australia isn’t just dominated by commodities and energy. We’re also the property punters of the world, with the oversized banking sector to match.

The good news is that our financial sector is set to benefit from rising interest rates…right?

Well, on the day the Reserve Bank of Oz surprised us with a 0.5% rate hike to a nosebleed-inducing 0.85%, (defying the need to get back to the round numbers Australians are used to), bank stocks tumbled instead of rising as expected.

The Australian Financial Review had the surprising figures:

All of the big four banks ended the day sharply lower, with losses ranging from 2.3 per cent for ANZ Bank to $23.89, NAB down 3.9 per cent to $28.91, CBA down 4.4 per cent to $97.47 while there was a 6.1 per cent fall to $21.98 in shares to Westpac.

This is a very, very bad sign for our economy.

You see, the financial sector is supposed to benefit from higher interest rates. The reason is simple, although it’s never made much sense to me, as it happens.

Higher interest rates mean higher profits for lenders. Isn’t it that simple?

Nope, because banks’ cost of funding can rise too; indeed, in a sense, the RBA’s interest rate hike is just that — an increase in the cost of bank funding. At first glance, an interest rate hike is bad news for banks.

But banks, of course, simply passed on this cost to borrowers by raising their own rates, which they charge their borrowers.

This exposes what’s really going on. Banks make money based on the net interest margin — the difference between their cost of funding and their lending income.

Banks are intermediaries, more like oil refineries than oil producers. It’s about the margin, not the price.

That banks do better under higher interest rates is a historical tendency, not a fact. Banks tend to be able to raise their interest rates more than central banks do during tightening cycles. ‘Tend to’ are the key words. Their cost of funding rises slower than what they charge borrowers, growing their margins.

The problem with the current cycle in interest rates is that it’s got some unusual features to it. Which is bad news for banks and the rest of us too.

Consider, for example, real interest rates. These were a mighty confusing topic until recently. A bit like the concept of stagflation was tough to grasp until it happened.

Real interest rates are the interest rate adjusted for inflation. If you borrow money at 4% and buy widgets, whose prices rise by 5%, then you’re onto a winner of sorts.

The real point is that debt becomes a lot less risky. For example, a business’s inventory might be rising in price faster than their cost of capital.

But what about the lender?

Sure, bank interest rates may be around 4% and rising. But inflation is at 5%. That means, in real terms, banks are losing money, in a sense. They borrow from the RBA at 0.85%, lend to you at 4%, and then prices go up 5%.

It’s not much of a business model, even if I am simplifying things a lot.

Until real interest rates get to realistic levels, meaning positive, lending is an iffy business proposition.

But that real interest rate is only part of the problem. You’ve also got the housing bubble, which is at risk of popping, at last.

As Shylock from The Merchant of Venice will tell you, collateral can be very important in a lending agreement.

If its value is rising, then the lender can hardly lose. The rising value of the house protects the bank from the consequences of default.

But falling collateral values are dangerous because they can make default a rational action. In the US, this was known as jingle-mail. Borrowers simply defaulted and left the bank with the house, which was worth less than the debt.

Another threat to the current cycle is just how fragile things are to begin with.

Unlike in previous cycles, when interest rate hikes could just be reversed, the RBA’s interest rate is only at 0.85% and there’s already signs of trouble.

If the property bubble pops now, or there’s a recession, there’s not much room for rescuing the economy or the property market anymore. The financial firemen are out of water.

This is the natural endgame for a fiat money system, of course. Just as the drugs stop working for an addict, the magic money tree eventually stops working too. Especially if you overdo it, like during a pandemic.

Next up in the list of bad news for banks is default risk. The economy is sputtering while interest rates go up. That’s not a good combination for lenders. The prospect of bad debts is rising.

This is especially risky in a cycle where an entire cohort of borrowers simply aren’t familiar with rising interest rates. Indeed, the current hikes are the first in almost 12 years!

And the RBA had promised not to raise rates for another two years…

Meanwhile, the Australian building industry is imploding. Which is odd given the surge in house prices. But, again, these are margin businesses. It’s about the differences between the cost of building and the price sold at.

Fixing your sales price without fixing your costs is a dangerous business that will inevitably go wrong eventually. It’s just a question of when. Not that people in the industry had much choice.

The tumult in the building industry is leaving committed borrowers and prospective homeowners out of pocket, limiting future lending opportunities for banks. They’ll struggle to make up for negative real margins with volume, in other words.

All this is just another example of how economics is simply not linear enough to lend itself to government and central bank policies. The same rate hike can have diametrically opposite impacts depending on a long list of conditions.

Some German economists discovered the corollary long ago, although I can’t find their study anymore.

According to economic wisdom, savers should save less when interest rates fall, because the incentive is lower.

But the study showed that German households actually responded to lower rates by saving more, because they had to make up for the lost income they had been counting on for their nest egg.

So even the most basic concepts and assumptions of economics continue to surprise policymakers. And investors, as Aussie bank shareholders, and the RBA learned the hard way…

Until next time,

Nick Hubble Signature

Nickolai Hubble,
Editor, The Daily Reckoning Australia Weekened

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