Moody's: Diverging interest rates will widen profitability gap between US banks and global peers

The profitability gap between US banks and global peers will widen over the next 12 to 18 months as US interest rates rise and persistently low or even negative rates in Europe and Japan intensify profitability pressures on their banks, says Moody's Investors Service in a report.

"We expect the US Federal Reserve Bank to progressively increase interest rates over 2017/18, allowing US banks to earn higher interest on their lending activities and investment securities," says Michael Rohr, Vice President and Senior Credit Officer at Moody's. "In contrast, we expect interest rates to continue to remain very low in Europe into 2017 and 2018, and pressures on profitability will likely grow as a result."

Rising rates will support US banks' net interest margins and income due to the high share of interest-sensitive and largely variable-rate assets in US banks' balance sheets contributing to their revenues and profitability. In addition, most commercial loans are generally linked to one- and three-month LIBOR and therefore highly reactive to changes in short-term interest rates.

For European banks, the continued downward re-pricing of loans, in a context of funding costs which have little room to reduce further, will intensify profitability pressures. Banks with a high share of net interest income as a percentage of their revenues and a low share of interest-sensitive wholesale funding, such as small, regional banks in Germany and Switzerland, are most at risk.

"European banks that rely on both a high share of household deposit funding and a high share of revenues from net interest income will be most exposed to profitability pressures," explains Mr. Rohr. "This is because these banks will be increasingly constrained in their ability to pass on extremely low or even negative interest rates to their non-corporate depositors, leading to a faster compression of their net interest income."

When short-term interest rates eventually rise in Europe, a scenario Moody's currently anticipates for the first half of 2019, some banks exposed to long-term fixed-rate assets would face a profit shock because their funding costs will rise much more rapidly than their lending rates. Germany's savings and co-operative banks, France's mutualist groups and Switzerland's cantonal and regional banks would be more exposed to a reversal of interest rates, in Moody's view.

In Japan, too, the negative interest rate policy will continue to put pressure on domestic banks' profitability because negative interest rates will adversely affect banks' net interest income, Japanese banks' main revenue source at 68% of total revenues.

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