BNM defends recent OPR hike to 3%, saying it was to avoid greater unease of higher inflation

By Priyatharisiny Vasu & Syafiqah Salim 

/ theedgemarkets.com 

12 May 2023

Bank Negara Malaysia governor Tan Sri Nor Shamsiah Mohd Yunus says the central bank wanted to guard against a situation of raising rates too little and allowing inflation to resurge, or raising them too much and causing unnecessary economic weakness.

KUALA LUMPUR (May 12): 

Bank Negara Malaysia (BNM) defended its recent position of increasing the overnight policy rate (OPR) to 3% amid widespread misconception, saying the central bank wanted to avoid keeping the rate too low for too long when economic growth was firm. 

BNM governor Tan Sri Nor Shamsiah Mohd Yunus said at the briefing on the first quarter of 2023 on Friday (May 12) that the central bank wanted to guard against a situation of raising rates too little and allowing inflation to resurge, or raising them too much and causing unnecessary economic weakness. 

“I must also correct the perception that we want growth to be slower. That is certainly not true. Which one is more kejam (brutal)? [A rise in the] OPR, or if our inflation goes out of control? 

If our inflation level heats up, all our purchasing power will be impacted regardless of whether you have a loan or not,” the governor said. 

She added that prolonged low interest rates that are not aligned with the health of the economy could have damaging effects, such as overspending and overborrowing. 

 “This could push up prices even more. When that happens, all of us will be affected, especially the poor and vulnerable,” Nor Shamsiah said. 

 It can also encourage excessive risk-taking, and speculative investments to get higher returns, and increase chances of financial scams. 

 She added that the central bank wants economic growth to be on a sustainable trajectory, and as such, it is focused on ensuring the long-term impact of its policy rate decisions. “We want it to be sustainable, not just for today, but for months and years to come. We do not want to have a situation, where we just look at today’s growth numbers, but further down the road, it's not sustainable, where it leaves us in high inflation and even a recession. That is not what we are here for,” Nor Shamsiah said. 

 On May 3, BNM raised the OPR by 25 basis points (bps) to 3%, as the central bank believed the global economy continued to be driven by resilient domestic demand. The rate hike, after two consecutive pauses in early 2023 at 2.75%, came as a surprise after most economists predicted that the central bank would maintain the OPR to further assess the impact of four straight increases in the key rate last year that raised it by a cumulative 100 bps. 

 Inflation remains sticky 

 Nor Shamsiah said although headline and core inflation is expected to moderate over the course of 2023, core inflation would remain elevated. 

 Elevated underlying inflation has been more prolonged than in past episodes, the governor said, adding that it was partly owing to a strong recovery in domestic demand. 

 “While core inflation moderated to 3.9% during the [first] quarter, compared with 4.2% in the immediate preceding quarter, it remained elevated relative to the historical norm of around 2%,” she said. Core inflation is more indicative of demand pressures, she said, adding that both headline and core inflation will remain within 2.8% to 3.8% for the year as a whole. 

 “Even as cost has begun to moderate, strong economic activities have continued to generate demand-driven pressures, which have kept core inflation elevated,” the governor said. 

 She said higher core inflation could be observed beyond conventional demand indicators, such as retail trade and credit card spending data. 

 Existing price controls and fuel subsidies will be continued to partly contain the extent of upward inflationary pressures, according to her. 

 “The balance of risk to the inflation outlook is tilted to the upside, and remains highly subject to any changes in domestic policy, financial market developments and global commodity prices,” she said.

https://theedgemalaysia.com/node/666714

Trade-off of limited interest rate hikes by Bank Negara

 Bank Negara’s tempered OPR hikes limit interest rate risks for banking system …

… but there is a trade-off

As with everything in life, there is a trade-off. And as we have always said, there is no free lunch in economics. 

• First, savers could have obtained more had interest rates gone higher. With high inflation, savings are now earning negative real rates (that is, below inflation) (see Chart 5).
• Second, the trade-off is a weaker ringgit — and higher cost of living for all Malaysians. 

The interest rate is the price of money (or credit or time, if one is inclined to be argumentative) — and it certainly is one of the major drivers in foreign exchange movements (see Chart 6); although this relationship is by no means linear or perfect. 

• Can a country maintain a relatively low interest rate while also stabilising its exchange rate?  
• Is the weak ringgit a function of the interest rate differentials between the ringgit and other currencies or are there even more dominant factors? 

https://www.theedgemarkets.com/node/662043

‘Balancing of raising rates too much versus not enough’

‘Balancing of raising rates too much versus not enough’
November 16, 2018, Friday

WASHINGTON: The US central bank is aiming to prolong the economic expansion but must balance the risk of raising interest rates too much or not enough, Federal Reserve chairman Jerome Powell said.

Amid increasing concerns in financial markets that the Fed will have to become more aggressive to head off inflation, Powell likened the job to walking in a dark room full of furniture.

In a discussion about the economy with Dallas Federal Reserve Bank President Robert Kaplan, Powell said the central bank is trying to steer between two common errors.

Holding the benchmark lending rate too low for too long could allow inflation to gain a foothold, he cautioned.

But the “other mistake – and we had plenty of advice to do this – is to raise rates too soon, and prematurely terminate an expansion.

“We haven’t done that,” Powell said.

However, “We’re at a point now where we have to take both of those risks very seriously, and that’s why we’ve been raising rates quite gradually.”

Economists almost unanimously expect the fourth rate increase of the year in December, but with a recent report showing wages finally beginning to rise, they are watching for indications about the likely pace of moves in 2019.

The Fed has repeatedly said it is likely to continue to raise rates gradually, with inflation holding right around its two percent target despite very low unemployment and continued job gains.

But Powell stressed that officials have not made the decision yet and will watch incoming data.

Likening the policymaking to “walking through a room full of furniture and the lights go off,” Powell asked, “What do you do? You slow down, you stop probably and feel your way. It’s not different with policy.”

The Fed chief also noted that the global economic outlook is slightly less optimistic this year.

There have been “growing signs of bit of a slowdown, and it is concerning,” he said.

Asked about the impact of President Donald Trump’s aggressive trade policies on the economy, Powell said while officials hear complaints from businesses, the effect of higher tariffs have not yet showed up in lower growth or higher inflation.

“We’re very pleased about state of the economy right now,” he said.

“If you look down the road you see challenges ahead” and “we have to be thinking about how much further to raise rates and the pace at which we will raise rates.”

Starting in December, Powell will hold a press conference after every policy meeting, rather than just four times a year, which he said means markets will have to get used to the possibility a rate move could come at any time. — AFP

http://www.theborneopost.com/2018/11/16/balancing-of-raising-rates-too-much-versus-not-enough/

Bill Gross: Financial markets are artificially priced. Discounting of future profit streams by an artificially low interest rate results in corresponding high P/E ratios. Real estates are affected in the same way.

Financial markets are artificially priced. In the bond market, there is nothing normal about a three year German Bund yielding a “minus” 10 basis points. Similarly, UK Gilts and U.S. Treasurys have in recent years never experienced such low yields and therefore high prices. The same comparison can be applied to stocks. While profits in many cases are at record highs, the discounting of future profit streams by an artificially low interest rate results in corresponding high P/E ratios. Real estate cap rates, which help to price homes and commercial shopping centers, are affected in the same way. While monetary policy with its Quantitative Easing and forward guidance for low future interest rates have salvaged a semblance of growth and job gains – especially in the U.S. – they have brought prosperity forward in the financial markets. If yields can’t go much lower, then bond market capital gains are limited. The same logic applies in other asset categories. We have had our Biblical seven years of fat. We must look forward, almost by mathematical necessity, to seven figurative years of leaner: Bonds – 3% to 4% at best, stocks – 5% to 6% on the outside. That may not be enough for your retirement or your kid’s college education. It certainly isn’t for many private and public pension funds that still have a fairy tale belief in an average 7% to 8% return for the next 10 to 20 years! What do you do?

Well the obvious advice on a personal level: Retire later, save more, accept a revised standard of living. But the financial advice varies with your age and willingness to take risk. Younger investors with a Texas Hold’em “all in” attitude could push all of their chips onto the equity table. Boomers nearing retirement probably cannot afford to. A lengthy bear market could force them permanently out of the game. So, one size does not fit all here. It never has.

What might be applicable for most generations, however, is an “unconstrained strategy” that I managed well for the past few years at PIMCO and which now provides me the opportunity for 100% of my time at Janus. An unconstrained strategy sounds very open-ended, and it is. But it allows a professional and experienced investment firm like Janus to select the most attractive alternatives across many asset categories while hopefully diminishing the risk of bond and stock bear markets. The strategy seeks to protect principal while providing an acceptable return in this low yielding, low returning world that I have just described. Unconstrained investors should expect a shorter average maturity for bonds; an ability to profit from currency movements currently taking place with the euro and the yen fits the description as well; taking advantage of what is known as “optionality” and investing in what I have successfully applied in the past with what is called “structured alpha,” would be an important component too. The simple explanation of an unconstrained strategy:

Take your best ideas within the context of a low duration/short maturity portfolio and try to help investors achieve what they consider to be an acceptable return. Watch the fees as well.

Whatever your risk/return persuasion, whether it be stocks, bonds, unconstrained, real estate, or “other,” an “intelligent investor” (as initially described by Benjamin Graham in the late 1940s) should be aware that returns almost necessarily cannot equal the magnificent prior decades that some of you might have experienced during my days at PIMCO. But I/we look forward, with the same intensity and “client comes first” attitude that led to my second marriage at Janus. James Bond famously said that “you only live twice.” I hope to emulate Mr. Bond as Janus Denver and Janus Newport Beach link hands and ideas to improve your financial balance sheet, and ultimately provide a better life for you and your family. Perhaps you only dance twice too. Sue and I would like that.

https://finance.yahoo.com/news/bill-gross-only-dance-twice-153815259.html

The Sources of Risk in Stock Investing

Total Risk = Unsystematic Risk + Systematic Risk

Unsystematic Risk (diversifiable)
Business Risk
Financial Risk

Systematic Risk (nondiversifiable)
Market Risk
Interest Rate Risk
Reinvestment Rate Risk
Purchasing Power Risk
Exchange Rate Risk

The Sources of Risk in Stock Investing

Total Risk = Unsystematic Risk + Systematic Risk

Unsystematic Risk (diversifiable)
Business Risk
Financial Risk

Systematic Risk (nondiversifiable)
Market Risk
Interest Rate Risk
Reinvestment Rate Risk
Purchasing Power Risk
Exchange Rate Risk

Corporate Finance - Business and Financial Risk

To further examine risk in the capital structure, two additional measures of risk found in capital budgeting:

1.Business risk
2.Financial risk

1.Business RiskA company's business risk is the risk of the firm's assets when no debt is used. Business risk is the risk inherent in the company's operations. As a result, there are many factors that can affect business risk: the more volatile these factors, the riskier the company. Some of those factors are as follows:

• Sales risk - Sales risk is affected by demand for the company's product as well as the price per unit of the product.
• Input-cost risk - Input-cost risk is the volatility of the inputs into a company's product as well as the company's ability to change pricing if input costs change.

As an example, let's compare a utility company with a retail apparel company. A utility company generally has more stability in earnings. The company has les risk in its business given its stable revenue stream. However, a retail apparel company has the potential for a bit more variability in its earnings. Since the sales of a retail apparel company are driven primarily by trends in the fashion industry, the business risk of a retail apparel company is much higher. Thus, a retail apparel company would have a lower optimal debt ratio so that investors feel comfortable with the company's ability to meet its responsibilities with the capital structure in both good times and bad.

2.Financial RiskA company's financial risk, however, takes into account a company's leverage. If a company has a high amount of leverage, the financial risk to stockholders is high - meaning if a company cannot cover its debt and enters bankruptcy, the risk to stockholders not getting satisfied monetarily is high.

Let's use the troubled airline industry as an example. The average leverage for the industry is quite high (for some airlines, over 100%) given the issues the industry has faced over the past few years. Given the high leverage of the industry, there is extreme financial risk that one or more of the airlines will face an imminent bankruptcy.

Read more: http://www.investopedia.com/exam-guide/cfa-level-1/corporate-finance/business-financial-risk.asp#ixzz1yewzbr6X

Will the great interest rate gamble pay off?

Will the great interest rate gamble pay off?
By flooding the system with 'free’ money, the central banks could be storing up trouble.

Since arriving at the European Central Bank, Mario Draghi has engineered a sort of Club Med putsch, sidelining the German hawks and embarking on monetary activism Photo: REUTERS

By Jeremy Warner

8:50PM GMT 02 Feb 2012

Bravo, Mario Draghi, the European Central Bank’s new president. Everyone assumed that this mild-mannered Italian would be so determined to prove himself to his Bundesbank masters that he’d be even more German than the Germans in pursuit of the principles of sound money. The profligate Italian of caricature would become the hair-shirted German, lashed to the mast of the Bundesbank’s anti-inflationary tradition.

In practice, he’s proved anything but. Since arriving at the ECB, Draghi’s engineered a sort of Club Med putsch, sidelining the German hawks and embarking on the kind of unconventional monetary activism that for several years now has been the hallmark of the US Federal Reserve and Bank of England. He’s been bold, and he’s been decisive.

And it appears to have worked. In promising unlimited funding to Europe’s stricken banks, he’s very likely saved the Continent from the Lehman’s moment for which it was undoubtedly heading. Both Spain and Italy have also found it easier to fund themselves in financial markets, and spreads have narrowed. Banks have been encouraged to borrow cheaply from the ECB to buy higher-yielding government bonds – the “Sarkozy carry trade” – which in turn has allowed countries to finance themselves less expensively.

By the time this month’s auction is over, the ECB will have doled out nearly one and a half trillion euros of “free” money to help keep the banking system alive, with much more to come over the months ahead.

Nobody is under any illusions. These actions have not succeeded in vanquishing the crisis. Underlying structural issues remain unresolved, and it is most unlikely that the starvation diet to which much of the eurozone periphery has been condemned will result in robust recovery. But Mr Draghi has at least prevented the patient from dying on the slab. Two cheers for that.

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Even so, you have to wonder where all this “financial repression” – the artificial depression of interest rates – is going to lead. Since the crisis began, the world’s major central banks have engaged in a degree of intervention in financial markets quite without precedent in the modern age, if ever. In seeking salvation from the banking maelstrom, interest rates have been cut close to zero, and long-term bond yields suppressed to historic lows.

In Britain, the Bank of England has already bought up more than a third of the conventional gilts market, or rather more than a quarter of the entire national debt. Since quantitative easing began, the Bank has hoovered up gilts to the value of more than a half of those issued by the Debt Management Office, greatly easing its task in financing the deficit.

Nor is this the limit of the UK’s financial repression. Banks have been required by regulators greatly to increase their liquidity buffers, creating another big source of demand for UK gilts. It’s the same in the US and Europe.

These sovereign debt holdings have created new threats. Given the inflated size of the buffers, it would require only a quite small rise in interest rates – one or two percentage points – to create additional solvency problems for the banks, as we saw with the Franco-Belgian bank Dexia, which had to seek a bail-out after its eurozone sovereign debt turned toxic. Yet it is the rapid expansion of central bank balance sheets which is beginning to cause greater concern.

There are a number of justifications for this expansion. One is that by printing money, the central bank counters the contraction in credit being caused by private and banking sector deleveraging. By so doing, the monetary authority keeps the deflationary bogey at bay.

But it also allows governments to issue debt at lower interest rates, reducing servicing costs and eroding the real value of the debt. Economists have described it as a form of stealth taxation, or debasement.

It’s not an ideal way of proceeding, and it’s deeply unfair on savers, who through negative real interest rates are obliged in effect to subsidise both the Government and other debtors. It is, however, generally considered less painful than the alternative of even greater fiscal austerity.

For the moment, it’s hard to argue that such actions are inflationary. Today’s relatively elevated levels of UK inflation are not directly caused by money-printing, but by devaluation and the spike in energy prices. The problem is not too much money, but not enough. Yet intuitively, one knows that some way down the line, such practices will have inflationary consequences which, once out of the box, will be extremely hard for central banks to put back in again.

Only last week, the US Federal Reserve committed itself to keeping interest rates close to zero for another three years. By the time we get there, the US will have had seven years of essentially “free” money. Nobody knows what the long-term consequences of such financial repression might be. As I say, it’s never been tried before. But we do know from the way unduly loose monetary policy helped stoke the credit bubble in the first place that the potential for things to go very badly wrong is high. Central banks frequently seem to do more harm than good.

In the US, credit conditions already seem to be easing. Recent evidence points to sustainable growth of some 2 to 3 per cent. As the economy normalises, so must interest rates. The fear must be that we’ve grown so used to and reliant on ultra-low rates that the economy won’t be able to tolerate anything else. The dangers are all too obvious.

http://www.telegraph.co.uk/finance/financialcrisis/9057320/Will-the-great-interest-rate-gamble-pay-off.html

How interest rates affect your share portfolio

GREG HOFFMAN

November 5, 2009

When most people hear the term ''interest rates'', they think of the official cash rate (consciously or otherwise). This rate is set by the Reserve Bank board each month and is important because it impacts the cost of short-term finance, including the rates charged on variable rate mortgages.

The official cash rate is used as both an economic accelerator and handbrake by the Reserve Bank. When economic conditions turn down, as they have over the past 18 months, lower cash rates stimulate economic activity. When the Reserve Bank board believes things are heating up, it raises rates to slow them down; as it has done at its past two monthly meetings.

It's important to be aware of the official cash rate but there's another rate that should have as big a bearing on your sharemarket investment decisions as the official cash rate does on your mortgage: the 10-year government bond rate. There are several reasons why this is an important rate.

Firstly, it's a decent guide to future movements in short term rates. In January, buyers of 10-year government bonds were locking in a return of less than 4% for the coming decade. By June, that figure had risen to 5.8%; to anyone tracking this key measure, recent rises in the official cash rate would have come as no surprise.

Another reason why the 10-year bond rate is important is that it is typically viewed as an investor's ''opportunity cost''.

As a long term investor, by buying a 10-year government bond you can currently lock in a return of a little over 5.6% for the coming decade.

As it essentially involves lending money to the Federal Government, the 10-year bond rate is often referred to as the ''risk free interest rate''.

So, to take on the considerable risk of investing your money in shares, you need to be confident of an average annual return well in excess of this risk-free rate. In this way the 10-year bond rate exerts a ''gravitational pull'' on sharemarket returns; the higher the bond rate, the less a prospective investor will be inclined to pay for shares.

That's because our hypothetical investor will demand a higher return from the sharemarket to lure them away from the safety of government bonds. And, using this frame of reference, we can intuit a few things about the relative value between the sharemarket and the bond market.

Back in January, as the sharemarket was approaching a low point, the 10-year bond rate sank below 4%. This meant the gravitational pull on share prices was very weak by historical standards; bonds weren't offering much return compared with the dividend yields provided by a portfolio of blue chip shares.

Since January, the equation for share investors has become more treacherous; the 10-year bond rate has surged to 5.6% at the same time as share prices have risen strongly. In other words, 10-year bonds look more attractive than they did in January, while stocks look less so after having already risen by so much.

Capital growth eyed

Buying a portfolio of Australia's top blue chip stocks will likely provide a dividend return of less than 3.5% over the coming year. So today's buyer is counting on a decent amount of capital growth to ensure they're ahead of the safe-and-sound government bond investor, at the same time as shares have already delivered remarkable returns from their low point.

It's not impossible that the sharemarket will rise strongly from here, but it's much less likely to do so than it was back in January. Interestingly, though, while short term rates were nudged up this week by the Reserve Bank, the 10-year bond rate has eased a little over the past fortnight - from 5.8% to 5.65%.

This has occurred in tandem with the past fortnight's sharemarket hiccup. And if both of these trends continue (lower bond rates and a falling stockmarket), then the equation for sharemarket investors will improve once more.

Our analysts would rarely let broad financial or economic factors stop them buying a good share at a sensible price.

But it's all part of the backdrop we consider when going about our daily search for sharemarket bargains and provides some useful food for thought.

http://www.businessday.com.au/business/how-interest-rates-affect-your-share-portfolio-20091105-i05w.htm

Reviewing the basics of interest-bearing investments

To have a good understanding of interest-bearing investments, learn and know the followings.

The risks of interest-bearing investments, for example:

• inflation,
• interest rate cycles and
• dubious borrowers with poor credit ratings.

The advantages of investing in this asset class, particularly

• the interest income on which you can rely.

Some of the main interest-bearing investments in the market.  These include: 

• cash,
• money market funds,
• bonds,
• participation mortgage bonds and
• voluntary purchased term annuities.

You have to know about two new market places other than the stock market: 

• the money market, where short-term interest-bearing secuities are traded, and
• the bond market, where longer-term interest-bearing securites such as bonds are traded.

Mistakes to avoid when investing in interest-bearing instruments

Interest-bearing investments may be relatively stress-free, but they too have their pitfalls.  Watch out for the following:

• Do not accept the first interest rate you are offered.  Compare interest rates, negotiate where possible and find out more about fixed versus fluctuating interest rates and the term of fixed-interest investments.
• Do not think interest-bearing investments are safe, risk-free havens.  Remember the impact of inflation.
• Do not forget about interest rate risk.  When interest rates increase, bond prices will decrease, resulting in a loss on your investment.  The longer the term of the bonds, the greater the drop in the market price.
• Do not invest in bonds without understanding the terms of the bonds and the interest rate environment.  Invest in well-known and reputable bonds rather than in unknown corporate bonds.

More about another interest bearing investments: bonds

Bonds are fixed-income securities that governments and companies issue in order to borrow money.  They pay interest to you for that privilege. 

The maturity date is the date on which the full amount that was borrowed is returned to you .

The investment term is normally a fairly long period, say ten years or longer.

The coupon is the interest rate you receive. 

Bonds are traded on the capital market in the same way that equities are traded on the stock market.

Bonds are medium-risk investments because the interest rate cycle has a definite impact on the value of bonds. 

If you want to understand bonds, this is the most important thing to remember:  when interest rates fall, bond prices rise; when interest rates rise, bond prices fall. 

This is simply because the coupon on the bond is fixed, and the market value of the bond is adjusted to bring the coupon in line with the external interest rate. 

Bonds are a very important part of a well-diversified portfolio.  In difficult stock markets, bonds can provide a cushion to soften the blow.

The calmer waters of interest-bearing investments: their risks and rewards

The interest-bearing investments include:

• cash
• bonds
• the money market securities.

Compared to the roller-coaster ride of equities, interest-bearing investments are like a sea of tranquillity.

The focus of interest-bearing investments is not on the appreciation (increase) of the capital you have invested, but rather on the provision of a steady interest income - often at a fixed rate.

While shares offer you higher returns at a higher risk, interest-bearing investments offer you lower returns at a lower risk, making them a safe haven for many investors.

But this safe asset class is not safe from inflation. 

Interest-bearing investments often do not generate the kind of return that beats inflation, and it is very important to remember that interest income is taxable.  After taking tax into account, the return on interest-bearing investments often struggles to beat the inflation rate.

The reason for this is simple.  Interest-bearing investments are normally money you lend to a bank, government, company or other institution with the undertaking that this exact amount will be paid back after a period of time. 

In return for this, you earn interest.

Since you only get the same amount back after a couple of months or years, that amount is usually worth less as a result of inflation. 

Your only real benefit is the income that you receive.

Interest-bearing investments also hold other risks. 

• This asset class is subject to the ups and downs of the interest rate cycle.  As interest rates increase or decrease, your cash flow can be affected - unless you have a fixed interest rate.
• Furthermore, you should beware of institutions with credit risk.  A high interest rate is not everything:  you must also be sure that your capital will be paid back. 

The so-called junk bond market in America is well known as a market where companies with poor credit ratings offer exceptionally high interest rates.  Sometimes it is better to earn less interest, but know that your money is safe.

Interest-bearing investments do, however, play an important part in an investment portfolio.  Although inflation will still erode the capital value of your investment, these investments do have advantages, including:

• offering you a relatively safe and predictable income.
• offering you less risk and volatility than an investment in equities
• offering diversification in your portfolio in case stock markets collapse
• giving you instant access to cash when you need it.

Banks - It's All about Risk

Whether a financial institution specializes in making commercial loans or consumer loans, banking is centered on: risk management.

Bank accepts 3 types of risks:

• credit,
• liquidity, and,
• interest rate,

and they get paid to take on this risk.

Borrowers and lenders pay banks through interest or fees because they are unwilling to manage the risk on their own, or because banks can do it more cheaply.

But just as their advantage lies in mitigating others' risk, banks' greatest strength - the ability to earn a premium for managing credit and interest rate risk - can quickly become their greatest weakness if, for example, loan loss grow faster than expected.

How banks report their revenue and income

Let us look at how banks report their revenue and income.

Unlike traditional firms, there is no explicit "revenue" or "sales" line. Instead, there are four major components to examine:

1. Interest income
2. Interest expense
3. Non-interest (or fee) income
4. Provisions for loan losses


Here's an example of how the top of a bank income statement will look:

$1000 Interest income
- $ 500 (less) Interest expense
----------------
$500 Net interest income
- $ 100 (less) Provisions from loan loss
+ $ 500 (add) Non-interest income
----------------
$ 900 Net Revenue



Let's ignore the non-interest income component in our further discussion because this is generally steadier than interest income and interest expense.

Interest income
less Interest expense
----------------
Net interest income
less Provisions from loan loss
----------------
$ X


We can see that banks have a natural hedge built into their business.


Consider the following as a base case for a bank operating in a strong economy:

$1000 Interest income
-$500 Interest expense
----------------
$ 500 Net interest income
-$100 Provisions from loan loss
----------------
$400

Suppose now that the Federal Reserve cuts rates. Because the Fed understands the benefit of maintaining a strong balance system, subtle cues are generally communicated before any cut. In the meantime, the banks reposition their balance sheets so that they're liability sensitive, thus allowing net interest income to widen.

However, if a cut happens, it's for a good reason. A recession might be causing unemployment to rise and bankruptcies to increase. That in turn, leads to higher provisions for loan losses for banks. Here's what might happen in a weak economy:

$1000 Interest income
-$400 Interest expense
----------------
$ 600 Net interest income
-$200 Provisions from loan loss
----------------
$400


Have interest rates impacted the bank? Yes and no. Sure, net interest income widened, but this number is meaningless in isolation. After all, the weak economy caused provisioning to double, thereby wiping out the wider interest spread.

In the real world, this relationship doesn't come out to the perfect round numbers laid out here, but it can be close.

• From 2000 to 2001, for example, FDIC data shows that net interest income grew $16.1 billion for the banking industry, mostly because of lower rates.
• However, the weakening economy caused banks to give most of that benefit back in the form of $13.8 billion of increased provisioning.

Virtually all banks can benefit in this type of scenario. However, big banks also have additional tools at their disposal.

• For starters, the breadth of their business lines makes it easier for them to reposition their balance sheet to focus on one sector versus another, depending on the operating environment.
• Perhaps, most importantly, big banks have the ability to access the capital markets to pass the buck by letting investors purchase the loans (much like a bond) and assume the interest rate risk. Then banks - which still service the loans and collect a fee doing so - can focus on their strengths: credit and liquidity risk management.

At the end of 2002, for example, Bank One owned just $11.6 billion of credit card loans - those it held on its balance sheet - yet it managed a total card portfolio of $74 billion. This has happened industrywide and highlights the strength of larger lenders. For instance, although commercial banks and savings banks held 56% of all US consumer loans on their balance sheets in 1990, that number had fallen to 37% by the end of 2002. Why? Because securitized assets - those that are sold off to investors and that banks continue to service - had risen from 6% of loans outstanding to 35%, according to the Federal Reserve.

Thus, while margins can be impacted by interest rates, large financial institutions are making progress toward managing the interest rate cycle. As you're thinking about interest rate risk, remember that the impact it has on a bank's balance sheet is complex, dynamic, and varies from institution to institution.

Making sense of direction and level of Short term interest rates

Strategy: Short term interest rates will tend toward the inflation rate plus the economic growth rate

There is always a great deal of discussion about interest rates, particularly US rates. Short term rates are set by governments and this can be a fascinating process to watch. The rates affect the economy and many of the markets.

The benchmark strategy helps to make sense of discussions about their direction and their level. It is a rough guide which is often missed by many commentators. With this rough valuation target, interest rates are easier to understand than most markets, where it can be hard to have a clue what the prices should be. Equities, the market that most investors concentrate on, do not have this kind of benchmark.

An interest rate is made up of the inflation rate plus a 'real' rate. That is, the real interest rate is what is left after allowing for inflation.

Interest rate
= Inflation + 'Real interest rate'

The economic growth rate is the percentage expansion or contraction in the economy with inflation stripped out. It can be loosely considered as the dividend paid by the economy in general.

Economic Growth rate
= Rate of expansion or contraction in the economy - Inflation

Rate of expansion or contraction in the economy
= Inflation + Economic Growth rate

Over time, the real interest rate moves towards the economic growth rate. In that way, the return from interest rates and the return from the economy in general, are equal.

In 2005, the short term rates in the US are 1%. When they start to rise, how far could they go? In the US in 2005, you may wish to target 4% because inflation was around 2% and growth was also around 2%. Add them and you get the target.

Rates had started moving lower worldwide and the question was, how far they could fall? Using the rate of contraction in the economy and the inflation rate gives you an estimate of the economic growth rate. As over time, the real interest rate moves towards this economic growth rate, using this simple strategy, you can have an idea how much further interest rate could move and in which direction.

As the level of interest rates are somewhat predictable, this benchmark strategy helps you to invest intelligently in the bond market.

Interest rate risk

Interest rate risk

Interest rate risk is the chance of a loss in portfolio value due to an adverse change in interest rates.

When interest rates change, the value of a fixed income security also changes.

Rising interest rates depress bond prices, and vice versa.

Default risk: Default risk is the same as credit risk. It reflects the fact that a borrower might be unable or unwilling to honour the terms of an agreement to pay principal and interest on a loan.


Also read: Understanding Risk
Partitioning Risk
Business risk
Financial risk
Purchasing power risk
Interest rate risk
Foreign exchange risk
Political risk
Social risk

Impact of Interest Rates on Stock Prices

Impact of Interest Rates on Stock Prices

Warren Buffett highlighted the impact of interest rates on the Dow in a speech he gave on the stock market in July 1999. To demonstrate the correlation between interest rates and stock prices, with the exception of the inflation figures, he provided the data below which depicts two 17-year periods, between 1964 and 1981, and 1981 to 1998.

31st December
Gain in GNP over each 17 year period (%)
1964 – 1981…..373
1981 – 1998…..177
DJIA
1964—874
1981-- 875
1998--9181
Interest on long term government bonds (%)
1964-- 4.20
1981-- 13.65
1998-- 5.09
Increase in consumer price index over each 17 year period (%)
1964 – 1981…..201
1981 – 1998……74

Note:

The inflationary effect on asset values together with retained profits and new capital issues would have significantly increased the book values of the companies comprising the Dow during the first period 1964 – 1981. Yet, in spite of the huge increase in GNP, the 1964 index figure was basically the same 17 years later. Prices had been subdued by a more than threefold increase in interest rates.

In the second 17-year period from 1981 to 1998, in spite of GNP growth and inflation being less than 50 percent of the first period, the Dow increased by 949 percent. The driving factor was declining interest rates that diverted money out of interest-bearing securities into equities.

Interest rates increase at times of high inflation partly to offset the diminishing value of money and the government’s desire to curb demand in what is seen to be, as measured by GNP, a fast-growing economy. Conversely, when inflation subsided in the second 17-year period, interest rates declined.

Interest Rate Risk

The changes in interest rate have a bearing on the welfare of investors. As the interest rate goes up, the market price of existing fixed income securities falls, and vice versa.

This happens because the buyer of a fixed income security would not buy it at its par value or face value if its fixed interest rate is lower than the prevailing interest rate on a similar security.

For example, a debenture that has a face value of MR 100 and a fixed rate of 12% will sell at a discount if the interest rate moves up from, say, 1% to 14%.

While the changes in interest rate have a direct bearing on the prices of fixed income securities, they affect equity prices too, albeit somewhat indirectly.

The changes in the relative yields of debentures and equity shares influence equity prices.

How to analyze the market? Bank

Because the service that banks provide is so vital to long-term economic growth, the banking indutry is almost certain to grow in line with the world's total output, no matter which sector generates the greatest need for capital. Whether the demand for money comes from an industry such as technology or pharmaceuticals or consumers' incessant demand for housing, banks will benefit.

The banking business model is simple. Banks receive money from depositors and the capital markets and lend to borrowers,profiting from the difference, or spread. If a bank borrows money from a depositor at 4 percent and lends it out at 6 percent, the bank has earned a 2 percent spread, which is called net interest income. Most banks also make money from basic fees and other services, which is usually referred to as noninterest income. Combine net interest income and noninterest income to get net revenues, a view of the bank's top line. That's the banking model.

Interest income
- Interest expense
__________________
= Net interest income
- Provisions for loan losses
+ Noninterest income
__________________
= Net revenue


The low cost of borrowing - combined with the advantae banks have on the lending side - allows banks to earn attractive returns on their spread.

That said, because many banks enjoy these advantages, we think there are few that truly have wide economic moats. Money is a commodity, after all, and financial products are generic. So what makes one bank beter than another? Here are a few examples of wide-moat banks with different strategies:

• Citigroup uses its worldwide geographic reach and deep product bench to increase revenues and diversify its risk exposure, which allows it to perform well in even difficult environments.
• Wells Fargo is an expert at attracting deposits which area key source of lower cost funds, and it has a deeply ingrained sales culture that drives revenues.
• Fifth Third has an aggressive sales culture, a low-risk loan philosophy, and a sharp focus on costs.

It's all about Risk.

Whether a financial institution specializes in making commercial loans or consumer loans, the heart and soul of bnking is centered on one thing: risk management. Banks accept three types of risk:

1. credit,
2. liquidity, and
3. interest rate,

and they get paid to take on this risk. Borrowers and lenders pay banks through interest or fees bcause they are unwilling to manage the risk on ther own, or because banks can do it more cheaply.

But just as their advantage lies in mitigating others' risk, banks' greatest strength - the ability to earn a premium for managing credit and interest rate risk - can quickly become their greatest weakness if, for example, loan losses grow faster than expected.