General Banking and Finance Outlook
On the backdrop of the UK's economy entering a technical recession, interest rates remaining at 5.25% with an expected reduction to 4.5-5% by the end of this year (an expectation of two or three separate rate cuts of 25 bps subject to inflation falling in line with the Bank of England's expectations), reduced supply of cash, increased borrowing costs, geopolitical tensions, lack of investor appetite (despite there being sufficient dry powder being available amongst private equity firms and investment firms), and aggressive regulatory changes (“the Current Economic Factors”), both the appetite to lend and the ability to borrow will be negatively affected for the forthcoming year.
Interest Rates, Inflation and the 2024 Spring Budget
Interest rates remaining high throughout 2024 will, as seen in 2023 already, continue to have an impact on borrowing costs both for consumers and lenders on the interbank and financial markets. Despite higher interest rates giving banks and lenders a boon in returns in recent years the effect of higher interest rates is one of a double-edged sword in that it has also in turn led to margins being squeezed due to higher funding costs.
Further to the spring budget announcement on the 6 March 2024, the chancellor has confirmed that there will not be any cut or changes made to income tax and instead the chancellor has opted to utilise his approximated £18bn1 headroom (although this figure is disputed and is now subject to change bearing in mind the various new taxes and levys introduced in the spring 2024 budget which have increased the chancellor's projected headroom i.e. the introduction of vape duty, abolishment of non-dom status, revision to air passenger duty etc.) in be able to fund a further 2p cut to National Insurance. A cut to income tax at this stage was deemed to be more costly and inflationary in the long term than a cut to National Insurance.
It is argued that had the chancellor opted to cut income tax (depending on scope and scale) at this stage it would have resulted in the Bank of England having to wait until the beyond the summer before cutting the base rate2 as opposed to reducing the rate in the next Monetary Policy Committee in June (it is anticipated that rates will remain at 5.25% in the hearing on 21 March 2024 subject to any unexpected deviation in the rate of inflation). This would primarily be a move to ensure that inflation remains to fall in a downward trajectory in order to fall in line with the Bank of England's target of 2%.
Much of the Bank of England's decision to cut rates will also be dependent on the Federal Open Market Committee's (FOMC) meeting on the 20 March 2024 as well as their subsequent meeting the summer to decide on whether to cut rates from its current 5.25-5.50% range. In its previous meeting the FOMC indicated that until there is “greater confidence that inflation is moving sustainably toward 2 percent." This is a change from the tone used in their previous meeting in which three potential rate cuts this year were earmarked.3
As of writing US inflation has now fallen to 2.4% following data from the Bureau of Economic Analysis released on 29 February 2024 on Personal Consumption Expenditures (PCE) which notes that core rate for PCE (excluding energy and food price variation) is now 2.8%. PCE is the Federal Reserve's key metric for ascertaining price pressures and following confirmation of inflation now being at 2.4%, it will remain to be seen whether the Federal Reserve opt to cut rates in March or stick to waiting for inflation to come down sustainably to 2% before cutting rates.
UK Gilts
In respect of the UK gilt market, using a fair value model which incorporates global factors and domestic macro drivers ING estimate there's a 40 basis point risk premium in 10-year gilt yields, which suggests that markets are not immune to UK fiscal risk.4 For reference, the 2022 mini budget which caused market uproar due to the then incumbent government's decision to announce unfunded tax cuts with minimal Office of Budget Responsibility (OBR) oversight, led to a negative deviation in fair value at around 60 basis points. ING estimates that these early indications of a 40 basis point deviation suggest that markets are taking the uncertainty around the election into account in respect of pricing.
Net Effect on lending
Due to the Current Economic Factors and subject to the potential rate cuts and variances within the UK gilt and US Treasury bond market, loan growth is expected to be modest.5 Additionally, recent bank lending surveys conducted by the Federal Reserve and the European Central Bank (ECB) indicate that banks have already tightened credit standards across all product categories and anticipate further tightening of standards due to the Current Economic Factors and likely deterioration in security packages/collateral values and credit quality.67
However, the Current Economic Factors will not universally lead to a downturn in all loan product categories. For example, with consumer savings being depleted, demand for credit card and auto loans will remain strong.8 Generally it is expected that bank loans to corporates may weaken in the short term but could pick up later in 2024 following base rate cuts and a further reduction in inflation.9
Net Effect for Lenders
The Current Economic Factors will affect the ability of lenders to be able to generate income (both interest-based income and noninterest income) as well as manage expenses (both interest-based expenses and operational expenditure).
With rates expected to remain within the 4-5% range by the end of 2024, funding costs will remain elevated which in turn will squeeze margins and increase costs for lenders in relation to interest bearing deposits.10
Deposit costs are expected to affect larger banks and lenders more so than smaller banks and lenders. For example, in the US deposit costs for the largest banks stood at 2.2% in Q2 2023, compared to 2.5% for the smaller banks. There is a similar trend in countries that have seen rate hikes such as the UK and countries within the EU.11 Lenders will seek to reduce these costs but may struggle to do so in the wake of customer expectations of higher rates and increased competition.
The amalgamation of higher deposit costs, lower policy/central bank rates, and somewhat constrained loan potential may adversely impact lenders' ability to generate a strong net interest margin (NIM) in 2024.12 Currently, It is expected that US and European lenders will see a decline in NIM in 202413 which will require them to seek alternative channels to generate noninterest income for example via increased consumer fees. This will be easier for lenders with advisory, underwriting or corporate banking franchises who should have scope to increase their fee income via the backlog of deals and issuances and clearer valuations.14
In respect of the major UK banks, Fitch Ratings estimate that despite higher interest rates leading to the retraction of net interest margins coupled with asset-quality deterioration, higher funding costs and competitive pressure on lending margins the performance of the largest UK banks will only be affected slightly.15 This is primarily due to the major UK banks' leading funding franchises, proven access to wholesale funding markets, and central bank facilities which should ensure that profitability remains strong.16
Footnotes
2. Ibid.
3. https://www.cnbc.com/2023/12/13/heres-whatchanged-in-the-new-fed-statement.html
6. https://www.ecb.europa.eu/press/pr/date/2023/ht ml/ecb.pr230725~8358d3939d.en.html.
9. Ibid.
10. Ibid.
11. Ibid.
12. Ibid.
13. Ibid.
14. Ibid.
16. Ibid.
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