Low and negative interest rates pose one of the greatest challenges to banking profitability around the world. Net interest margin (NIM), which is the difference between interest earned on assets and the cost of funding, is the first line of defense for banks. Higher NIM means more resources at hand to tackle bad debts, set aside provisions, accumulate capital buffers and make distributions such as dividends. It is therefore not surprising that thinner NIM often corresponds with lower profitability, especially in the negative interest rate policy (NIRP) areas of the world (see Figure 1).
There remain parts of the world, however, where banks continue to enjoy decent NIM, and Asia offers several cases in point. Indonesia’s four largest banks on average earned around 7% net interest margin during the last 12 months while India’s largest retail-focused banks generated close to 4% during the same period.
So what are their secrets?
Strong NIMs can be first and foremost explained by these countries’ higher interest rate environments compared to developed markets. Central banks in these countries often keep real policy rates higher in a conscious effort to maintain resilience to external shocks, as well as in response to higher inflation and inflation expectations.
Second, pockets of strength in loan demand (such as residential mortgages in India) and moderately tight banking sector liquidity (Indonesia’s loan-to-deposit ratio in local currency is above 90%) also grant greater pricing power to banks over their customers.
Third, history lessons from past swings in credit costs make these banks generally more conservative in loan pricing.
Finally, large retail-focused banks can benefit from low-cost, deposit-based funding, which is particularly beneficial when loan interest rates are high.
The significance of net interest margins
Policymakers can be somewhat conflicted over high bank margins – lower NIM corresponds to lower borrowing rates, while higher NIM means higher borrowing rates but healthier bank profits to fund future growth. It is an important balance to strike.
For example, China’s four largest banks on average earned a NIM of more than 3% between 2008 and 2015 under a semi-regulated interest rate regime (before interest rates were liberalized in late 2015). This period coincided with the country’s well-known credit-fueled growth phase when private sector credit relative to GDP increased by over 50%.
A healthy banking sector is crucial to the sustainable growth of an economy. If policymakers are the brain sending directional signals to the muscles and joints ‒ the various real economic activities – the banking sector is the spinal cord, ensuring the smooth transmission of those signals. Safeguarding reasonable margins is therefore an essential prescription (though certainly not the only one) for sustaining the health of not only the banking sector but the economy as a whole.
Implications of Asia bank NIMs for investors
Are generous NIMs in Asia here to stay? Probably not. NIMs in many Asian countries are expected to decline over the long term, thanks to low global rates, improving external profiles, structurally lower inflation and a milder asset-quality cycle.
But for now, decent NIMs, coupled with the current moderate asset-quality cycle (a topic for another discussion), should be conducive to credit expansion in at least selective pockets of these economies, which ultimately helps support the growth outlook for these countries.
Based on credit fundamentals, we have a benign view on the Indonesian banking sector and a more mixed view on Indian banks, where we see pockets of strength in retail-focused businesses offset by vulnerabilities elsewhere in the system. In general, we favor high-quality, hard-currency senior banking credits. Our assessment of the financial sector also forms an indispensable part of our view of a country’s overall economic condition. Consistent with our credit views, we have a fairly constructive outlook for the Indonesian economy and expect a neutral-to-improving trajectory for India.