Tightening interest margins: erosion of banks’ bottom line?

  • Business
  • Saturday, 12 Apr 2003

By Rating Agency Malaysia Bhd

ALTHOUGH Bank Negara recently indicated that interest rates would stay at the current levels, the main challenge for banks now is still managing with narrowing interest margins.  

Domestic interest rates are already at competitive levels.  

Furthermore, they are currently at their lowest since 1997. The banking system’s intervention rate is currently at a low of 5.00 per cent (in contrast to a high of 11.00 per cent in 1997), while the statutory reserve requirement rate stands at 4.00 per cent (vs. 13.50 per cent as at 1 June 1996). 


Bank Negara

Would further tightening of interest margins lead to the erosion of banks’ bottom lines? Are interest margins the main determinants of profitability? 

Interest margin is defined as the difference between the yield on average earning assets (average lending rate) and the cost of funds (average cost of funds).  

Generally, interest margins will be squeezed if average lending rates fall and/or average costs of funds increase.  

Interest margins have decreased slightly since 1999.  

However, it has not been as dramatic as most people have perceived.  

In fact, it is interesting to note that the current squeeze on interest margins appears to be a result of competitive pressures within the banking industry, rather than due to regulatory constraints.  

The intense competition has lowered the lending rates for newer approved loans (especially home loans). 

The average lending rate and base lending rate for commercial banks appear to be converging.  

This is an indication that commercial banks are no longer maximising their margins by earning a spread of 2.50 basis points above the base lending rate. 

While tightening interest margins will definitely have a direct consequence on banks’ bottom lines, we note that asset quality plays a crucial role in cushioning the impact; there is a strong correlation between loan loss provisions and pre-tax profits. 


Asset quality – the fundamental factor  

When interest rates were initially slashed in 1998, banks’ bottom lines had been affected when net interest income declined by 11.11 per cent to RM14.87 billion from RM16.71 billion in 1997.  

At that time, banks had been more dependent on interest income, where 77.17 per cent of their gross income comprised net interest income.  

During that period, the main components that impaired the banks’ bottom lines were loan loss provisions rather than net interest income, despite the margin squeeze experienced then.  

Loan loss provisions climbed as high as RM17.40 billion in 1998, which led to a loss for the entire banking sector.  

To add salt to the wound, the weakened economic scenario then led to a contraction in loan growth, further affecting banks’ net interest income. 

We are of the view that as long as banks maintain their asset quality, the impact on their bottom lines would not be as detrimental as during the crisis period.  

Asset quality is the fundamental factor in our bank rating analysis.  

The financial performance of a bank is never analysed in isolation. A bank that records a less-than-spectacular performance does not evoke much concern, so long as its overall asset quality remains intact. 


Enhancement in non-interest income  

Although net interest income remains the banks’ bread and butter, the composition had been reduced to 71.63 per cent by end-2002 (from 77.17 per cent on 1997).  

Looking at the figures from 1997 to 2002, there has been a general trend for banks to gradually increase their focus on non-interest income.  

Non-interest income, comprising mainly fee-based income as well as income from Islamic banking activities, has gradually increased. This may help cushion the effect of tightening margins on banks’ profitability.  


Stable and gradual loan growth  

In their efforts to capture market share via price competition, banks have now thinned their spreads. This has attracted many consumers to take up loans, as evidenced by the loan growth for retail banking.  

With such competitive rates in the market, we expect loans to continue to grow modestly, especially the retail banking sector.  

Furthermore, most commercial banks are also gradually enhancing their market share in the financing of small- and medium-sized industries. 


Synergies from consolidation  

The consolidation of the banking sector had been expected to improve efficiency, enhance operations as well as yield cost savings to some extent.  

However, these effects have yet to be manifested in the banks’ performances. These factors would also assist in cushioning the effects of thinner spreads for interest margins. 



Overall, further tightening of interest margins would definitely have a direct impact on banks’ bottom lines.  

However, this should not be viewed in isolation.  

While banks may record lower net interest income should their margins narrow further, we believe that asset quality indicators should be viewed as a more critical tool in the assessment of banks’ financial performance.  

Given that asset quality is currently manageable, banks will record relatively lower interest-in-suspense and loan loss provisions, therefore translating into better bottom lines. 

Furthermore, we believe that banks are now more prepared to face a further decline in interest rates.  

As mentioned earlier, efforts have been expended to enhance non-interest income levels.  

Moreover, cost savings arising from the mergers have yet to fully come into play. 

All these factors have to be taken into account when gauging the effects of a further squeeze in interest margins.  

However, further reassessment may be required should the war in Iraq and the recent outbreak of the Severe Acute Respiratory Syndrome exert an adverse impact on asset quality. 

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