Reduced Viability? Banks, Insurance Companies, and Low Interest Rates
Almost all major US banks comfortably passed the US Federal Reserve’s stress tests last month.
While that’s certainly good news, the purpose of these tests is to determine whether banks “have effective capital planning processes and sufficient capital to absorb losses during stressful conditions,” not whether they can earn a risk-adjusted return even close to what they were accustomed to in previous decades.
And there is reason to wonder about that, for both banks, insurance companies, and indeed any institution that generally depends on the spread between short liabilities and longer assets for its profits.
Such spreads are largely vanishing as benchmark yields around the world continue to hit new lows. Earlier this month, yields on both Japanese and German 10-year sovereign bonds entered negative territory. The 10-year US Treasury yield hit an all-time low at under 1.4%.
How Do Low Interest Rates Affect Bank Profitability?
The Fed recently released a paper entitled “‘Low-for-Long’: Interest Rates and Net Interest Margins of Banks in Advanced Foreign Economies” that considers precisely this question. The study looked at bank profitability in advanced financial economies during low- and high-rate environments between 2005 and 2013.
A low-rate environment was defined as a time when a country’s three-month sovereign bond yield was 1.25% or below, while a high-rate period was when that yield was above 1.25%.
Though asset and liability composition were similar in both environments, the findings indicated a strong link between interest rates and net interest margins (NIMs). That relationship intensified during low-rate periods:
“The new empirical analysis shows that low rates are contributing to weaker NIMs and identifies an adverse effect that is materially larger when interest rates are low. It suggests that these effects can be material for banks in some key advanced foreign economies.”
At bottom, banks have little leeway in a low-rate environment. They can only cut their funding costs so much. Theoretically they can charge negative deposit rates, but most have been reticent to do so. Instead, they’ve kept retail deposit rates at or near zero as yields decline.
The implications are straightforward: Unless banks are willing to charge negative deposit rates, their NIMs are likely to continue contracting as yields on earning assets reprice lower, which has certainly been the trend.
So Banks Look Cheap for a Reason
After years of pricing in many interest rate hikes on bank equities, investors have started to sober up and price in a greater likelihood of low rates remaining.
Based on headline ratios, bank and insurance company stocks look attractive. Traditionally, investors focus on price to tangible book ratios for banks, which are well below long-term averages.
But, as always, looks can be deceiving.
In this case, banks are trading so low because their profitability has plummeted since the financial crisis. Book multiples typically move in lockstep with return on equity (ROE), and material incremental ROE upside is unlikely if interest rates remain so low.
Should the current rate environment continue, a further erosion in profitability will occur as assets reprice while liability funding remains static. This will cause net interest margin compression and therefore lower returns on equity absent higher leverage.
Banks Are Vulnerable
It’s true that banks are well capitalized and have greater liquidity. Their capital ratios are high and loan losses are low. But lower profitability means lower earnings, and that will make it harder for banks to build capital during the next credit cycle.
An environment of low profitability can also cause banks to push the envelope and lower their lending standards or lengthen the duration of their assets to boost profitability. This could include holding longer duration whole loans on balance sheet, making incrementally riskier loans, or purchasing securities with more credit and/or duration risk.
To some degree, the firms themselves are to blame for their difficult straits. Many speculated that interest rates would rise and positioned their asset-liability exposure to benefit disproportionately from rising rates (and suffer more consequences if rates fell). They have given up current income in favor of floating rate over fixed-rate loans and kept the duration profiles of securities holdings very low.
One notable exception, however, is Wells Fargo, which put on a large interest rate swap over a year ago that converted its floating rate exposure to fixed-rate, thus locking in higher income if rates remained low at the cost of reduced flexibility if they rose. As it happened, rates barely budged and the bet paid off. But Wells Fargo was the exception.
An additional complication: With so many banks trading at valuations well below their tangible book value, some analysts are starting to call for stock buybacks. Should the current interest rate environment continue for a long time, these pressures will only intensify.
Headwinds for Insurance Companies.
Like banks, insurance companies attempt to earn a spread through an asset/liability framework. In the current interest rate environment, this has become more challenging.
MetLife CEO Steven Kandarian commented during the first quarter 2016 earnings call that “Yen Whole Life sales were down 60% in the quarter. This sales decline was intentional, as it is difficult for this product to generate attractive returns and acceptable cash payback periods in a negative interest rate environment . . . Overall, top-line growth is a challenge in the current low-rate environment.” He continued, “to combat the pressures of growth from low rates in a weak macroeconomic environment, we must address our cost structure.”
But, like the banks, insurance companies can only slash expenses so much to offset the pressures of lower rates, and the longer those rates persist, the less likely the cuts will mitigate margin pressure over the long term.
These rate pressures are starting to be reflected in the price of insurance stocks, with MetLife’s stock price, for example, falling roughly 30% over the last year as of the end of June, to 66% of tangible book value.
Why Do Rates Keep Falling?
This question has been asked repeatedly since the financial crisis, but has only grown more confounding over the last year. Many investors assumed that as the labor market healed, inflation would begin to rise, the Fed would hike rates, and the curve would steepen in anticipation of additional rate hikes.
Despite a tightening labor market and even some traction in wage growth, rates have continued to fall and the yield curve has continued to flatten. Explanations for this range far and wide, from the puzzling drop in productivity, to aging demographics, to slowing global growth, to the undue influence of central banks in the markets.
Increased regulations, particularly Basel III, have also driven incremental demand as banks are required to hold a certain percentage of potential outflows in high-quality liquid assets. More recently, the drop in sovereign bond yields has been even more pronounced in the wake of Brexit-related uncertainty.
Investors are wondering how the low rates can be justified given these headwinds and whether the assumed “return to normalization” might just be a delusion.
Should the Fed Lend a Hand?
As a supervisor and regulator of banks, as well as a key driver of the low interest rate environment, the Fed has done a lot and could do more.
Quantitative easing (QE) programs have injected trillions of dollars of reserves into the system through the purchase of bonds. These reserves will remain until the bonds are sold or until the runoff/maturities cease to be reinvested.
The benefit of these reserves — and the offsetting deposit liabilities — is that liquidity appears to be much greater than it actually is. However, since the purchased bonds are no longer available in the market, a shortage of safe assets has developed, which forces would-be Treasury and agency mortgage-backed securities (MBS) buyers into riskier assets.
Allowing the size of the Fed’s balance sheet to be reduced through runoff would arguably steepen the yield curve while increasing the supply of safe assets. Deposit outflows would occur as a result of reserves leaving the system, but overall the steepening yield curve should provide a tailwind to banks while normalizing the environment.
One can’t help but see the irony in the Fed’s position. Early in the QE program, those opposed to it speculated that the Fed’s real objective was to recapitalize the banks. Years later, amid worries about asset scarcity while the curve is flattening, detractors argue that the Fed’s bloated balance sheet has artificially influenced asset levels and the supply/demand of government securities.
The longer interest rates stay so low, the more margin pressure banks and insurance companies will come under.
To some, the change in behavior of financial institutions in this low-rate environment poses additional risks with unknown effects. Others are much more sanguine and view the environment as an amazing opportunity to buy financials at bargain basement prices.
Both views are held by intelligent people, but only one will be right in the long term. The important thing to remember is that who is ultimately correct will have more to do with the future path of interest rates, which is reliably difficult to predict, than any other factor. Against that backdrop, investors should be asking what it is that they actually own when investing in financial firms: a business or a spread play.
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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.
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