Inflation and Profitability

In my previous articles, I focused on the effect of inflation in the Loan losses, i.e., the cost of risk. A different angle to capture the other main block of the bank’s financials concerning inflation is the Net Interest Margin (NIM). Below you can find a picture used as an overall framework used in my book to give an overview of the main building blocks when analysing a bank.

?Previously we already saw that:

The Net Interest Margin is one of the components of the Operating Income are:

The Net Interest of a bank is given by the difference between the interest paid to fund its assets and the interest received from the asset:?

We can see some basic scenarios of Net Interest Margin based on different scenarios:

From scenario 0 to scenario 1, there is only an increase in the interest charged to the bank’s customers with no impact on the liabilities rate. This would be a scenario where all liabilities are fixed rate. From scenario 0 to scenario 2, we can see a similar increase in the rate (+1%) for both assets and liabilities. The NIM nevertheless improves given that the Interest Paying liabilities are lower than the interest paying assets (1000 vs 850). Finally, we can see from scenario 3 to scenario 4 that the NIM remains the same if both Interest earning and paying assets are equal and the increase in rate is the same (+1%).

From the basic examples we can therefore infer that most of the banks increase their NIM based on an increase in the interest rates. We can analyse some bank’s data presented in the Pillar 3 reports on IRRBB (Interest Rate Risk in the Banking Book) metrics to understand if that’s the case in practice.?

One of the metrics to measure IRRBB is the Net interest margin and its sensitivity calculated as the difference between the interest income as percentage of assets and the interest cost of the liabilities of the banking book in a determined time horizon, typically from one year.

Its sensitivity reflects the impact of changes in interest rates on net interest income in the given time horizon. Net interest margin sensitivity is calculated as the difference between the net interest margin in a selected scenario and the net interest margin in the baseline scenario. Therefore, the net interest margin can have as many sensitivities as scenarios considered. This metric enables the identification of short-term risk, and supplements another metric called economic value of equity (EVE) sensitivity.

So, in terms of the NIM, we can see that banks have an upside potential with the increase in the interest rates.

Sources:

Credit Risk: The Easy Path. From Rookie to Expert, Asif Rajani, 2022.

https://www.santander.com/content/dam/santander-com/en/documentos/otra-informacion-relevante/2022/02/hr-2022-02-25-2021-pillar-3-disclosures-report-en.pdf

https://www.hsbc.com/-/files/hsbc/investors/hsbc-results/2021/annual/pdfs/hsbc-holdings-plc/220222-pillar-3-disclosures-at-31-december-2021.pdf

https://www.ing.com/Investor-relations/Financial-performance/Annual-reports/2021/ING-Bank-appendices-Additional-Pillar-3-Disclosures-2021.htm