Forward curve warrants another look at IOR
Forward rates are surging. It is widely accepted that banks' income could increase markedly in such a scenario. This is not a given. Higher revenues are dependent on asset yields tracking short-rates higher. While historically this may have held true, the UK financial sector now sits on £900bn of cash reserve balances held overnight at the Bank of England. Current policy sees these balances remunerated at base rate. But if that holds, and the forward curve is right, Her Majesty's Treasury faces interest payments on reserves ("IOR") of £7-8bn per annum within three years. That's two-thirds of the cost of the recently announced Health and Social Care plan. Despite Treasury assurances, a return to a zero-rate band may be politically inevitable. For now, we are sitting tight. Such a change would be a major fiscal intervention by Government and one it isn't yet signalling. Neither is it likely until we’ve seen at least the first or second rate rise. The size of any zero-rate band would also be limited by operational factors. But it would be remiss not to explore this topic in a little more detail.
The issue is not new - but it is becoming more relevant. Reserve balances will total £900bn by year-end, almost double pre-pandemic levels. With cash markets pointing to a rate hike as soon as February, and at least two more discounted by Summer 2023, the cost of paying interest on reserves could soar. Yet taxes are also rising, as is the cost of living. Pressure on HMT to revisit this issue may build.
The BOE hasn't always remunerated reserves. In fact, interest on reserves has only applied in full since 2009. In an "ample reserves" regime, such as in the UK, we believe a sufficiently large portion of reserves need to be remunerated at policy rate in order to control overnight market rates. But that doesn't preclude a sizeable zero-rate tier.
There is precedent. Admittedly, the tiering of reserves at other Central Banks (for instance the ECB) is often intended to reduce the burden on the commercial banks of an otherwise negative deposit rate. But the same broad principle could apply here – albeit to reduce the burden on the Government of an otherwise positive deposit rate.
The sector’s sensitivity to higher rates could be reduced by 40-50%. Clearly this is highly dependent on the size of any zero-rate band. But at half of the reserve pool, the positive impact on domestic sector profits of a 25bps UK rate rise could fall from 5% to 3% (pre-mitigation). At NWG, the most rate sensitive, profit accretion would reduce from 11% to 7%.
As Sir Paul Tucker said earlier this year, at some point there must be a chance that the Government says to the Bank of England, “Can you not stop paying interest on Central Bank reserves?”. At over 15% of all funded assets, the outlook for reserves and their remuneration has important implications for the domestic banks sector.
It is a fiscal, not a monetary policy, decision. Some may view the payment of interest on bank reserves as a taxpayer subsidy. We disagree and believe a zero-rate band would constitute a tax on the sector. Governor Bailey concurs. Our analysis also suggests that almost half of reserves are held by non-UK banks. This could affect the competitiveness of the wider UK financial sector if other Central Banks - most notably the US Federal Reserve - do not follow suit.
Other important topics are also being overlooked - for instance, the refinancing hump in the mortgage market starting in late 2022 that will see a disproportionate amount of unusually high spread volume move onto much lower rates through 2023.
The broad point is that the sector is not without risk and it is feasible that in 2023 we could see significant revenue headwinds with only a limited offset from higher base rate (if rate increases emerge at all).
For now, we are maintaining our fairly constructive view on the domestic banks.
Distributions should be good enough, even on more negative scenarios, to prevent a sharp decline in share prices – and there is considerable option value if rates follow the forward curve with no change in reserve remuneration policy (which continues to be the position of the Treasury).
Even if there were to be a change in IOR, we doubt this would be implemented before the first or second rate rise. Similarly, mortgage business written two years ago is currently rolling off spreads that are lower than average back book rates. The refinancing headwind is a year away.
As always though, we think it is important to highlight the risks as well as the rewards – and be ready to change view if developments (including higher share prices) warrant that.
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