Banks: Leverage and the Interest Rate Spread

I've been railing against the slow adjustment in the interest rate margin between what Malaysian banks are charging and their cost of funds (proxied by the overnight interbank rate). Turns out they're not alone in doing this.

An article on VoxEU* examines the profit record of banks during the Great Depression, and makes some telling comparisons with current developments. To make a long story short, commercial banks are probably going to remain relatively healthy (at least, those that don't actually go bust), especially compared to their investment banking brethren. What really caught my eye though is the remarks about the interest rate margin - Euro area and US commercial banks are charging approximately between 2.5%-3.0% above their cost of funds, which is suffcient to handle an average loan portfolio default of about 5% over the next four years. That actually corresponds nicely with what Malaysian banks are charging:



If that's the case, the spread's likely to remain pretty much as it is until we get a handle on actual default rates later this year. Since we're looking at the bottom probably occuring in 2Q2009, that means defaults should peak some time in 1Q2010 assuming a sustainable recovery emerges in the second half of the year.

So we're at or close to the bottom as far as lending rates are concerned, though I still think banks could have cut faster in response to the cuts in the OPR.

In another VoxEU article**, the Research Dept of the Bank of Italy looks at leverage ratios in the global banking industry over the last ten years or so. As you may know, leverage before the crisis, which is the multiple of assets over the underlying capital base (or alternatively your gearing level)***, was sky high in some of the more badly affected banks - the US investment banks were allowed from 2004 to leverage their balance sheet up to 30x, which to my mind was insane.

If you like big numbers, that's 3000% of their capital base. I was surprised to learn that the Euro area banks actually had much higher leverage ratios (one bank exceeded 60x), which may explain why the European banking system was as badly affected as that of the US and UK. In any case, it's clear that leverage was a contributory factor in the fragility of the international financial system.

What are the leverage ratios in Malaysia? Not that bad by comparison:




Of course, this doesn't include off-balance sheet assets, but since domestic banking institutions haven't been that active internationally, I don't think the risk element is any higher than what is implied by the "official" numbers. Having said that, this is one metric I'm going to pay attention to in future.

Technical Notes
*"Lessons from banking profits in the Great Depression", Daniel Gros

**"Financial sector pro-cyclicality: Lessons from the crisis, Part I", Columba, F; Cornacchia, W; and Salleo, C

***There's a difference between leverage as defined here and the risk weighted capital ratio (RWCR), which is a reciprocal of the leverage ratio but with a difference in calculation. The RWCR (min: 8% under Basle I, equivalent to approximately 12x leverage) is based on risk weighted assets, where certain asset classes attract lower risk weights, which effectively reduces the value of assets used in the calculation.