A flat yield curve does not bode well for bank margins

The overall banking sector Net Interest Margins went up from around 270 basis points in FY 2018 to about 315 basis points by FY 2022. (Image: Shutterstock/Representative)

How does the steepness of the yield curve impact the profitability of banks?  This question is fundamental to understanding the relationship between monetary policy and the economics of banks.

Banks perform three critical transformations — that of risk, maturity, and lot size. Banks accept deposits with a very high promise of security to depositors and make risky loans and investments using these deposits which is the risk transformation. Banks also generally take short term deposits and make long term loans creating what is commonly referred to as an asset liability management mismatch (ALM) which is the maturity transformation. Banks also take small deposits from consumers and make large sized loans which is the lot size transformation. All these transformations are fundamental to the functioning of banks and create risks in their operations which the regulators try to keep in check using a repertoire of regulatory instruments. Bank managements, on the other hand, try to maximise their profits while staying within the risk limits which they impose on themselves as well as those that are imposed by the regulators.

Indian banking, like all banking systems across the world, rides on a structural ALM mismatch. The weighted average maturity of banking deposits is about 1.5 years while that of the loans is about 3 years. If we add investments to loans, then the average maturity of interest-bearing assets rises to about 4.5 years. With this level of structural maturity mismatch, a steepening yield curve will help banks improve their net interest margins (NIMs) which is the difference between the interest they earn on loans and investments, and the interest they pay on deposits divided by the total interest-bearing assets.

Figure 1 below depicts the NIMs for Indian banks for the 21-year period from 2002 to 2022 (Left hand scale) along with the term premium (right hand scale) which is difference between the one-year and the 10-year yields on government securities. The range around the average annual term premium is the range within which the daily term premia moved within the year. Clearly, this range has narrowed significantly in recent years suggesting lower volatility of the yield curve after the adoption of a flexible inflation targeting framework in FY 2016.

The chart shows a strong correlation between the term premium and bank margins. As the term premium rises bank margins tend to go up, albeit with a slight lag. From 2018 to 2022 as the RBI adopted an accommodative monetary policy, initially in response to the stress in the financial system after the collapse of IL&FS and then to deal with the COVID pandemic, the term premium widened to peak at an average of around 390 basis points in FY21 and FY22. Consequently, bank NIMs rose sharply for both private and PSU banks; the overall banking sector NIMs went up from around 270 basis points in FY 2018 to about 315 basis points by FY 2022. Private banks saw their margins go up by about 30 basis points from about 360 to 390 during this period while public sector banks saw an even higher gain of about 40 basis points from 222 to 262 basis points.

The period between FY 2014 and FY 2018 breaks this correlation between term premium and margins for PSU banks. This can be explained by the sharp rise in non-performing loans of these banks which resulted in ‘de-recognition’ of income which means that banks stop booking interest income on the loans declared non-performing, but do not take them off the balance sheet bringing the NIMs down. In the same period, private banks managed to increase margins by raising the share of high yielding unsecured personal loans and credit card receivables.

The period between FY 2006 and FY 2009 saw a decline in term premium as the interest rates went down in response to the global financial crisis. Both public and private sector banks NIMs went down. However, private banks regained NIMs quickly, mostly due to their focus on consumer lending. It is also important to note that until FY 2008 the overall banking system NIMs were very close to public sector bank NIMs as private banks had a much smaller share of Indian banking until then.

From May 2022, RBI tightened monetary policy with a 250-basis point increase in policy rates that has lifted short-term interest rates to about 7 percent now from around 4.5 percent. However, the long end of the yield curve has not gone up nearly as much and hovers around 7.2 percent. This has flattened the yield curve and the term premium has declined sharply to around 20 basis points now; it had declined to zero a couple of weeks back.

The data for the past 20 years suggests that such a flat yield curve does not bode well for bank margins, and we may see bank margins taking a hit in FY 2023 as the numbers come out. If the current flat yield curve continues, then FY 2024 margins may be even lower. In FY 2014 and 2015 we saw the lowest average annual term premium of around 15 basis points (compared to the long-term average of 100 basis points) and the lowest bank margins of the decade.

‘Managing’ the yield curve, especially the long-term yields may be motivated by the desire to keep cost of government borrowing low.  However, it may have the unintended consequence of hurting profitability of banking, a large share of which (around 60 percent) is owned by the government. Low margins limit the ability of banks to absorb credit losses.  With a flat yield curve as it is presently, we should all hope that credit risks remain contained and banks do not have to start providing for credit losses as they may not have adequate margins to do so.

Harsh Vardhan is a Mumbai based management consultant and researcher. Views are personal, and do not represent the stand of this publication.