The spectre of rising borrowing costs

-A +A

This article first appeared in Corporate, The Edge Malaysia Weekly, on May 30 - June 5, 2016.

AMID the rising cost of funds, tighter liquidity and falling margins, three banks opted to increase their base rate this month and consequently their base lending rate (BLR). Public Bank Bhd, Hong Leong Bank Bhd and Standard Chartered Bank (M) Bhd have increased their base rates by 10 basis points each to 3.75%, 3.94% and 3.77% respectively.

While the quantum is relatively small, the increase in base rates is worrying because Bank Negara Malaysia had opted to keep the overnight policy rate at 3.25% earlier this month. The central bank even reduced the statutory reserve requirement (SRR) in January to help boost the liquidity of banks, indirectly reducing the cost of funds.

So, are higher interest rates in the offing?

Rising rates could foreshadow weaker earnings by banks in the coming months. But of greater concern is the pressure these will exert on household debt and the slowing economic growth.

“There has been intense competition for funds among the banks over the past few months. They have had to increase their fixed deposit rates to attract deposits but this has increased their cost of funds, putting more pressure on their margins. Hence, the increase in the base rates that we are seeing,” explains an RHB Research economist.

“Other banks could follow suit to protect their net interest margins. However, because of the intense competition for loans, they may be reluctant to do so, especially if one of the largest lenders, Maybank, does not raise its base rate first,” he adds.

On top of being the largest bank in the country in terms of market capitalisation, Maybank also boasts one of the lowest base rates in the industry (see table). However, the fact that the third largest bank was willing to lift rates has made industry observers cautious.

“The cost of borrowing had already gone up, even before these banks increased their base rate. The spread that banks have been charging on the base rate — the ‘plus per cent’ on the base rate — has been going up. It isn’t obvious because most banks still advertise their best rates. This gets the customers through the door but only the top quality borrowers can get these rates. Many will have to pay higher rates,” explains a banker.

“Over the past two years, I estimate that spreads have gone up anywhere between 20bps and 40bps, depending on how competitive the bank is. And this is just the spread, not the base rate,” he adds.

It is important to be clear that a hike in the base rate directly and immediately impacts existing borrowers rather than the new ones since banks can still adjust their spreads to attract new applicants. This is why the so-called “best rates” advertised by banks do not vary much (see table).

Hence, it is possible for banks to remain competitive in attracting new borrowers while increasing the base rate. Looking at banks’ margins, it is no surprise that the rates would have had to rise at some point (see chart). The margins vary from bank to bank because different types of banking generate different margins. Commercial banking, for example, has higher margins than retail banking.

The downward trend, however, is clear across all banks.

Even during the good years, when loan applications saw steady double-digit growth, margins had already been on a downward trajectory. Now, with credit demand slowing, there will be even more pressure as banks compete for a shrinking pool of borrowers.

Keep in mind that the slowdown in investment banking activity will also reduce banks’ non-interest income. In turn, banks will come under pressure to maintain their NIMs to prop up earnings.

However, this may lead to a vicious circle as higher rates deter borrowers, particularly for the purchase of property.

“Rising base rates won’t be good for the housing market, which is already slowing down. We have already seen a slowdown in loan applications. If rates continue to rise, it would put even more pressure on the housing market,” explains RHB’s economist.

Housing loan applications fell 7.3% y-o-y to RM206.2 billion in the 12 months ended March 31. March marks the 18th consecutive contraction in loan applications.

However, the RHB economist qualifies that the quantum of the recent increase is still relatively small at 10bps. On this note, he also brushes off concerns that rising rates would pressure household debt, which now stands at 89.1% to gross domestic product. It would take a sharp hike of over 100bps to cause any real problems for borrowers, he explains.

Furthermore, with the decelerating economic growth at the moment, he hopes that Bank Negara will remain dovish in the coming months. The central bank’s reduction of the SRR has been a good indicator thus far.

The direct result of the SRR reduction was a sharp fall in the KLIBOR (Kuala Lumpur Interbank Offered Rate), which is a measure of liquidity in the system. The three-month KLIBOR had fallen from a high of 3.84% in December last year to around 3.67% last week. However, this is still substantially higher than the 3.2% the KLIBOR averaged at two years ago.

“The higher KLIBOR was partly due to capital outflows. The less money there is in the system, the less the liquidity and the higher the cost of funds for banks,” the economist explains.

That said, he does not anticipate any major shocks that would strain the KLIBOR going ahead. Even a rate hike by the US Federal Reserve would not have a significant impact.

“A Fed rate hike isn’t going to be huge. We are expecting only a small and gradual increase. While a US rate hike should cause capital outflows, I believe this is already priced into the KLIBOR, judging by the depreciation of the ringgit. Hence, a Fed rate hike won’t pose a big problem to domestic rates,” he explains.

Meanwhile, banks will have to worry more about deposits, which is one of the cheapest funds they can source. Deposits saw the first contraction in March, down 0.88% y-o-y, after deposit growth declined for over one year. In 2014, deposit growth had averaged 6.6% y-o-y.