We have seen interest rate cuts recently in many EM markets and we expect further rate cuts in most of the markets we cover. This monetary easing environment could pressure banks’ profitability.
Recent central bank rate cuts in Egypt and Sri Lanka follow similar moves in the US, India, Philippines, Mexico, Thailand and Peru. In terms of outlook, all 21 developing markets we have looked at are forecast to show either a flat or declining interest rate outlook over the coming 12 months. The median decrease across these markets is 50bps, with Tanzania (-200bps) and Ghana (-100bps) likely to experience the largest rate declines, while Bangladesh, China, Pakistan, Rwanda and South Africa are likely to see a flat interest rate profile.
Net interest income accounts for around two-thirds of bank revenues, and a 10bps margin squeeze knocks 5-6ppts off the typical bank’s earnings. Lower interest rates feed through into both lower asset yields and lower funding costs for banks. The relative size of these moves helps to determine whether bank margins (and profits) will be net beneficiaries or losers during a rate-cutting cycle.
On balance, most of the banks we have looked at are likely to experience lower margins and therefore (absent any changes to volumes and risk costs) weaker profits in a lower interest rate environment.
Margin implications of lower interest rates
Our analysis indicates that for every 100bps cut in interest rates, bank margins will decline by a median 10bps if considering structural sensitivity, but the median margin effect is close to zero if considering near-term sensitivity. The most negatively affected banks include those in the GCC, but also Rwanda and Pakistan banks. In contrast, margins for banks in Nigeria, Bangladesh and Mauritius should be structurally more resilient, while banks in Uganda and Tanzania could actually experience margin expansion in the near-term (most of their deposits reprice within one year, while many assets are either non-interest earning or reprice after one year).
Markets with the biggest differences between their structural and near-term mismatches include Tanzania, Uganda and Ghana, where in the near-term banks could benefit from cuts (large stock of short-term time deposits). In contrast, for Pakistan and UAE banks most of the negative impact of any rate cuts would be realised within one year (due to short loan repricing periods and stocks of cost-free deposits).
Profit implications of lower interest rates
Our analysis indicates that for every 100bps cut in interest rates, bank profits will decline by a median 5-6ppts if considering structural sensitivity. The most affected banks include those in Saudi Arabia (most deposits are non-interest bearing) and Qatar (high volume of non-interest-bearing deposits). In contrast, profits for banks in Nigeria and South Africa (higher proportion of interest-earning deposits at both) plus Uganda (lower profit sensitivity to rate cuts due to high weight of non-interest income to total income) should be more resilient.
Focusing on near-term sensitivities, GCC and Pakistan banks appear most negatively affected (note that we do not foresee any rate changes in Pakistan, however). In contrast, our analysis suggests that banks in Sri Lanka and Tanzania could actually benefit from lower rates, as most of the deposits reprice within one year while a good proportion of loans have fixed rates for longer terms.
Banks will reposition to mitigate the margin squeeze
Lower interest rates should facilitate stronger loan growth, and support asset quality. In addition, banks can realise mix shifts (eg, gravitating towards higher-yielding retail/SME lending, and/or focusing on lower-cost funding, such as current accounts). Headline sensitivities therefore likely overstate the negative impact of lower interest rates on revenues and earnings. Because bank management will take action to adjust to a lower rate environment, we think near-term (12-month) mismatches are more relevant for equity investors