Critics of the banks accuse them of boosting margins by failing to pass on Bank rate cuts to borrowers. The banks' last trading statements, however, complain of downward pressure on net interest income. Who is right?
The chart below shows estimates of average interest rates charged on M4 lending and paid on M4 deposits, derived from disaggregated Bank of England data. (The M4 data cover banks' and building societies' sterling business with UK households and corporations.) The difference between the average lending and deposit rates is a measure of banks' net interest margin.
The critics are factually correct to complain of a measly decline in lending rates. Between November 2007 and April 2009 Bank rate was cut by 525 basis points but the average interest rate on M4 lending fell by only 310 basis points. This implies much lower pass-through than during the last big easing of monetary policy, in 2001-03, when Bank rate fell by 250 basis points and the M4 lending rate by 220 basis points.
The benefit to banks of a higher margin on lending, however, has been entirely offset by the disappearance of their deposit margin. In November 2007, the average interest rate on M4 deposits stood at 4.6%, 115 basis points below Bank rate of 5.75%. By April 2009, it was 110 basis points higher – 1.6% versus 0.5%.
In other words, the M4 deposit rate fell by only 300 basis points between November 2007 and April 2009 – slightly less than the average lending rate. Far from bolstering their profits at the expense of hard-pressed borrowers, banks have actually suffered a further decline in their net interest margin over this period – see chart.
Why has the average deposit rate proved so sticky? Clearly the maximum possible fall would have been 460 basis points – its level in November 2007. In practice, banks have been forced to continue to offer interest on sight (i.e. instant access) deposits in order to retain funds – not least because of competition from state-run savings. Meanwhile, the unforeseen collapse in Bank rate has left them temporarily saddled with high term funding costs: the average interest rate on household bank time deposits was still 4.6% in April 2009.
As term funding matures and is refinanced at lower rates, banks should be able to reduce the M4 deposit rate towards Bank rate. Coupled with higher margins on new lending, this should allow a significant recovery in the lending / deposit rate spread. As the chart shows, the spread is currently at an historical low – even a 100 basis point rise would simply return it to the average over 1999-2005, before the recent credit bubble.
Banks are already being accused of profiteering despite a further squeeze in their net interest margin; imagine the furore if they succeed in boosting their profitability. Such a development, however, is needed to speed capital rebuilding and support future lending growth. Moreover, restoration of the margin to a normal level is the mirror-image of an appropriate repricing of credit risk – spread compression in 2006-07 contributed to the lending bubble.
