Essay Example on Bank Interest Rates

Background of Study

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Bank interest rates in many developed countries have plummeted to low levels ever since the much infamous global economic slump (GES). Such a situation is expected to continue for an unknown period. It is a common knowledge among economists that the low interest rates are vital in the parameters that revive economies and also greatly enhance the balance sheets and performance of banks through the support of asset prices and the reduction of non-performing loans. However, it is also common knowledge that persistency in low interest rates can implicate the profitability of banks negatively since these low rates are basically akin to decreased net interest margins (NIMs). NIMs are the quotient of the division of banks net interest income by the earning interests.

Generally, measuring the return on assets reveals that the profitability of banks within the developed countries has recovered from the GES. However, the recovery is still of little significance and has since remained low implicating profitability challenges that are attributable to low values of net interest margins and increased occurrences of non-interest income and weal loans. This gradual and long-term decline in the net interest income across various advanced economies can only be pointed to lower interest rates since the global economic slump. The erosion of euro zone banks profitability due this slump is cumulatively estimated to be a loss of 230 billion US dollars of net interest income within the period running from 2007 to 2012 only. Mckinsey

Indicators of Performance

Net Interest Margins

The net interest margin is the quotient of the division of banks net interest income by the earning interests. The effects of low interest rates on the net interest margin do much outweigh the benefit of these low rates on the banks long term profitability. Banks are always reluctant to lower the rates of deposits especially below the zero mark, for several deposits. This results into the compression of bank margins during decline in interest rates due to the need of banks to pass the declined rates onto assets on contractual terms of reprising like the floating of rate loans. This is made necessary especially to borrowers who may consider extra options in financing. Low interest rates also flatten the yield curve negatively affecting NIMs.

Return on Assets

The return on assets comes out to have experienced a mixed result from the low interest rates experienced due to the global economic recession. The prolonged interest rates are viewed to have increased the asset prices, hence higher returns on assets while resulting into a sequential decline in households and investors net interest. On paper, the declining yields associated with prolonged low interest rates cause rising bond prices and also an increase in fixed income investments.

Objectives

The very essence of conducting this study is to determine the effect of low interest rates on the performance of banks. A special emphasis is made on the euro zone HSBC bank due to its large proximity in terms of provision of a variety of financial services and its network all over the European continent. The objectives therefore that drive this study are to:

Obtain appropriate literature and information regarding interest rates and the effect on banks performance

Establish the relationship between low interest rates and net interest margin, NIMs and with the value of return on assets.

Assess the effect of low interest rates on net interest margin and return on assets within the euro zone citing HSBC bank.

LITERATURE REVIEW

Theoretical Review

This section of the study attempts to review the various studies and research done on the effect of low interest rates on the performance of banks. A vivid insight enables the research to identify research gaps and problems that should be addressed. Issues investigated under this section include; Information addressing the topic, global trends on low income rates after the global economic recession, effects of prolonged/ultra low interest rates on the net interest margin and the value of return on assets and the relevance of the investigated studies with this study.

The profitability of banks should increase with an increase in the interest rates since these banking institutions have large cash deposits that can be attributed to balances of their customers and the business activities they engage in. The banks profit through the marginal variations that result from their returns from the investment of this cash over a stipulated period of time and the interest rates they pay out back to their clients. An increase in the rates increases these earnings while a decrease has the reverse effect. These interest rates can also affect the profitability of banks through the bond prices. An increase in the interest rates reduces their profitability earned from the loans since there is minimum spread occurring between the federal money rates and the rate of the banks on their customer loans. There remains a thin veil between rates charged over the long and short term in these interest rate slump periods.

Due to the global economic crisis, the interest rates also plummeted all over the world. As a result, most economies were engaged into well thought monetary policy that began in 2008. Although full recovery of these rates have not been realized to the moment of this study leading some financial institutions to resort to negative rates of interests. Maintenance of these low rates is however on the books to encourage commercial investment, expenditure and increase. A study of the yield curves clearly reflects this situation.

As much as many operation costs are reduced by low interest rates through cheap bank capitals, prolonged low interest rates implicate limitations in the revenue generated from interest by the banks on a certain number of assets. Economic data reveals that there is a similar trend in the net interest margins that can be directly attributed to the economic slump that hit the world in the past couple of decades. Short-term lending and a concurrent longer term borrowing have seen some banks in developed economies diverge from this supposed regression.

Empirical Review

Bank level data from consolidated balance sheets and other relevant financial statements were used to verify the status of international banks. The data were obtained from Bankscope, which is business type database under the care of Fitch and Bureau van Dijk. The study sample covered a long financial period ranging from 1995 up to the year 2012 that was characterized by various cycles of economic significance and the global financial crisis. The data is obtained and updated annually and adjustments are done in various ways. The initial process involves the regulation of several mergers and acquisitions that happened over that period of time through the construction of pro forma entities at the level of bank holding. Broad coverage and inclusivity was censured by a selection method based on country size to cover several banking systems in the more advanced economies. As per The Banker Magazine, the adjusted sample therefore comprises of a hundred and eight pro forma banks, ensuring seventy percent coverage of global bank assets. Banks that run large global financial operations like HSBC fund their own services using multiple currency forms and have unlimited access to various markets. Such advantages affect their funding expenses and also other macroeconomic circumstances that have implications on the rate of lending demands.

The relationship between the level of interest rates and the gradient of the yield curve can be used to determine the value of the return on assets. Higher rates of interest are reminiscent of high profitability and positive performance by the bank under analysis. Short term lending interest rates on the other hand raise the banks interest margins thereby enhancing the it net interest income. Higher interest rates also increase the provisions for loan loss and characterize implications on the debt services expenses and probabilities of loan defaults leading to a subsequent reduction in the non-interest income. Therefore, the impact of low interest rates is more pronounced in scenarios of net interest income compared to those of non-interest income and related loan provisions.

RESEARCH METHODOLOGY

Philosophy

In this section the various methods and approaches utilized in the study to achieve the set goals and objectives are comprehensively discussed. These approaches imply how data was collected and the various analysis tools employed to churn the preferred results concerning the effects of low interest rates on the profitability and performance of banks. The objectives of the research outlined in the introduction segment are discussed in this section. Other topics also discussed in this area including the viability and reliability of this study is also validated in this segment. The major concern that this study attempts to bring to light is the extent of the impact of low interest rates on the performance of banks and other related financial institutions. An equally important problem that drove the development of the study is the need to establish the relationship and the effect of low interest rates on the net interest margins and the value of return on assets as indicators of performance. The rationale behind the relationship that exists between interest rates and alterations of the net interest margins and return on assets is based on lending over a long period and borrowing over a short period. The loans of a bank mature for a longer period compared to the funds deposited into its portfolio and other debts. A fall in the rates of interest therefore creates a situation of rapid decline in the banks funding mechanisms compared to the interest revenue, this results to an increase in the net interest margins. When this situation is continued for some time, the net interest margins fall in the long term due to loan repayments and renewal at more reduced interest rates. Thus, in the medium-to-long term, net interest margins are largely unrelated to the general level of market interest rates.

Research Design

To obtain the targeted research objectives, the study used exploratory design of research which employs a rather quantitative approach in research. An exploratory research design is adopted in this study since it is guided by set objectives and study goals to give detailed information on the matter at hand. The research is specific for developed countries and prefers specific citation to HSBC banks in the Euro zone; hence the data obtained must also be specific and have non-randomized sources. The researcher is therefore satisfied that the design adopted is appropriate for this particular study. The quantitative methods involved here involve observation and study of the relevant information without influencing it. The method is highly effective since it collects raw data and presents it in its current state.

Data Collection

The quantitative approach was applied in the process of collection and processing of data. The collected data is approximated in figures to help enhance the understanding of the research. The preference of quantitative data over qualitative data is due to the type of data being handled in this research which is majorly secondary data. Secondary data is relatively easier to access and has relatively low costs required for access and collection. To obtain the secondary data, literature from past and present literature were studied on banks in developed countries, especially Europe. Data on the regression in the rates of interest since the global economic slump; the impact of the ultra low interest rates on bank profitability; and the resulting variations in the performance indicators including net i...