Low Interest Rate Environment – Should You Still Buy Banks?

Ask around investors who recently bought banks – be it DBS, OCBC or UOB. Many would say that they bought Banks because it offers an attractive dividend yield of more than 5% (before dividend cap) in this low interest rate environment. Many complain that REITs, once loved by dividend investors, now offer low dividend yield, which defeats the purpose of dividend investing. 

In recent months, prior to the dividend cap, banks started to increase its dividends and pay out dividends quarterly. For instance, when asked by analysts the sustainability of the dividends, DBS representative replied that so long their net profit is growing and CET-1 ratio is within the range of 12.5% -13.5%, DBS will have the ability to maintain and even increase the dividend.  DBS CEO was confident of maintaining the dividend even if they assumed no profit growth. This surely attracted dividend investors to reconsider their strategy and buy banks for dividends. 

The dividend cap announcement by MAS came as a surprise for some investors. There are two camps among  investors, one would believe that banks will not cut their dividends, even if the payout ratio were to increase. On the other hand, there are investors who believe that it is a matter of time for Singapore banks to cut their dividends. 

For instance, DBS CEO in its latest earning call mentioned that without MAS’ guidance, they would have been able to maintain the dividend, on the condition that the situation does not worsen beyond what they have anticipated. They even have the capacity to raise dividends next year if the situation improves from now. This is probably due to the fact that DBS is comfortable tha their dividend payout ratio to be at 70-80% range for the time being and emphasised that it is all about the stability of the dividend rather than the pay-out ratio. After all, the move made by MAS is to ensure that banks have the capacity and are resilient to support lending to business and individuals through an uncertain period. 

In this article, we will discuss the attractiveness of banks in this low interest rate environment and whether investors should either start a new position or to average down their current position.

The Federal Reserve and Interest Rates

The challenge about writing this section is the fact that I did not study economics and do not really fully understand the significance of monetary policy and how it affects the economy. We hear news about the Federal Reserve cutting interest rates and banks cutting deposits and loans’ rates. However, there is more to interest rates. 

The main goal of the Federal Reserve in the United States to promote the goals of maximum employment and stable prices. The primary tool used by the Federal Reserve to conduct monetary policy to achieve the before-mentioned goals is the Federal Funds rate. It is the rate that banks pay for overnight borrowing in the federal funds market. Any changes in the federal funds rate will impact the borrowing costs and spending decisions for households and businesses as well as broader financial conditions. At the end of the day, interest rate manipulation has the effect of injecting strength into the economy by reducing the rate or avoid overheating by increasing the rate.

When interest rates go down, it becomes cheaper to borrow. This will result in households being more willing to buy goods and services. This is because low interest rates reduces the incentive for individuals to hold on to cash as less interest will be earned. This will increase demand for goods and services which will push wages and other costs higher, thus influencing inflation. Besides increasing spending, low interest rates would encourage people to obtain mortgages for a new home or to borrow money for greater spending. 

Lower interest rates result in borrowing costs being cheaper. This encourages consumers and firms to take up loans to finance greater spending and investment for expansion. With that, businesses can hire more workers, thus influencing employment.

When interest rates go up, it gives us a signal that the Central Bank’s intention is to contain inflation and stabilise prices, thus preventing the economy from overheating. This is because higher interest rates would restrain borrowing by consumers and businesses since borrowing cost is higher. 

The Federal Reserve cut its interest rate for the first time last year. At that point in time, United States’ economy was expanding at record length, the unemployment rate at historic lows and consumers continued to spend. The Federal Reserve decided to cut its interest rates amidst uncertainty around global growth and persistently low inflation. With limited ammunition to fight off a downturn, the interest rate cut was ‘insurance’ as the uncertainty and persistently low inflation pose major threats to the health of the economy. Just this year the Federal Reserve made two emergency cuts by slashing interest rates by 150 basis points in two weeks to combat the impact of the pandemic and prop up the economy. The emergency cut prevents credit crunch and financial market disruptions experienced during the Global Financial Crisis. 

The Federal Reserve met for the last time in September before the Presidential Election and it has updated its framework where it does not look into increasing interest rates until the end of 2023 and set new economic conditions to be met before raising interest rates. The Fed will only start to raise interest rates when labour market conditions return to the “maximum employment” and inflation has risen to 2% and is on track to moderately exceed 2% for some time. This means that interest rates hike will not be as quickly as before in the future to counteract inflation spikes.

Banks’ Source of Income

There are two sources of income that Banks derive from – Net Interest Income and Non Interest Income.

The chart below shows the income contribution by the two segments based on the latest financial quarter ending 30 June 2020. From the chart, we could see that Net Interest Income contributes the majority of banks’ income at the range of 60-65% while Non-Interest Income contributes the remaining 35-40% of banks’ income.

The point I am trying to put across is that a bank is not just about lending out loans to borrowers and receiving deposits from depositors. There is also the non-interest income segment even though it does not contribute the majority of the income. Therefore, growth in this segment, will in some way offset the decline in interest income to a certain extent. The question to ask is how capable the management can grow this segment, in which growth rate outpaces the rate in decline of interest income. 

Net Interest Income

Banks loan out money to borrowers and in return receive interest income. Banks also receive deposits from depositors and in return pay them interest for banking with them.

Net Interest Income is derived from the difference between what banks receive from lending and what banks pay out from receiving deposits. Another metric one will look at is Net Interest Margin. Referring to the image above, it is the difference between the average interest-bearing assets rate and interest-bearing liabilities rate. To put it simply, the banks earn from the spread between the deposits rates and lending rates.

The key to grow in Interest Income does not solely depend on NIM. One should not forget about the growth loan volume, which should not be neglected. Even if NIM remains at 1.6% for the next few years before Central Banks decide to increase the interest rates, Interest Income can still grow so long that growth loan volume remains healthy. In other words, if NIM is declining but the interest income is either flat or growing slightly, this shows that the growth in loan volume is able to offset the decline in NIM.  Therefore, NIM is viewed as a lever to greater growth rate when both factors are showing growth.

Non-Interest Income

The above image shows the source of revenue derived from the non-interest income segment. A Bank’s fee income is usually derived from Loan-related, Investment Banking, Wealth Management, Cards, Transaction Services and Brokerage.

Using DBS’ latest financial result, DBS derives its income from Brokerage, Investment Banking, Wealth Management, Loan-Related, Cards and Transactional Services. These are sources of income that do not depend on interest rates. Instead, growth in this segment depends on the capability of management to grow its business and be less reliant on interest income in this environment. 

One bright spot to look out for all three banks in SIngapore will be the Wealth Management segment. DBS has managed to double its income from this segment in 5 years from $599 million in 2015 to $1.29 billion in 2019. This shows the track record of the management and should translate to more confidence in investors that DBS can still grow its earnings in this environment. The increase in income in this segment could be the fact that DBS acquired ANZ’s wealth management a few years ago, bringing in additional $18 billion AUM from it. 

When deciding between three equally great banks for investment, the one criteria that decides all is whether the management has the ability to drive greater growth. In this case, where we are hoping that management can depend less on interest income in this low interest environment, we would like to research more on the bank that drove the greatest growth in non-interest income in 5 years. DBS delivered the most growth in this segment, where its revenue grew 33% from $3.687 billion in 2015 to $4.919 billion in 2019. This is also the reason why I chose to invest in DBS among the three banks as I believe that the bank has greater earning power than the other two to drive greater growth.  

Therefore, I believe that in the future, DBS has the capability and track record to grow at such a rate thus relying less on interest income.

Besides that, banks also engage in trading, realised gains from investment securities and other revenue such as rental income, share of profits of associations and gain on fixed assets that forms the remaining income for the banks. 

With heighted market volatility and customer hedging activity, it offers opportunities for trading income to increase. This trend in non-interest income is expected to continue in the coming quarters. 

Banks will actively realise gains in investments to offset the decline in interest fee income due to the fall in interest rates. When asked by analysts on DBS’ unrealised investment security gains to realise in the near future, DBS CEO replied that the bank has $1.5 billion marked-to-market gains in the book and will provide a cushion for the lower NIM. However, the question is how much gains the bank can realise in the short term against holding it into the future. This is because there is a trade-off when it comes to realise those gains. The CEO explained that realising those gains put further pressure to their NIM. The assets were purchased at higher yields, and whether to realise those gains early or let  depends on the outlook of rates. 

How Interest Rates Affect Banks

It is certain that interest rates affect banks’ profitability in the interest income segment. Interest rates have a direct relationship with Net Interest Income. Banks benefit from higher interest rates and vice versa. This means that low interest rates reduce the NIMs of banks thus reducing their profitability in this segment. 

As the Federal Reserve cut interest rates to zero in 2020, the biggest pressure on banks’ earnings will come from interest rates. This is because banks’ NIM is determined by major Inter-Bank Offer Rates such as LIBOR, SIBOR, SOR and HIBOR which typically follow the US Fed rate, thus directly related. As seen below, SIBOR rates were on a downward trend ever since the reduction in Fed rate in late 2019. This also resulted in DBS’ NIM to fall from 1.9% in 1H2019 to 1.74% in 1H20 and 1.62% in 2Q20.

As banks do not solely rely on Interest Income for earnings, having low interest rates can be positive for bank profitability when it comes to non interest income. Low interest encourages banks to shift from net interest incomes to non-interest revenue, such as fee-based and trading activities.

Interest rate decline provides a one-off boost to asset valuations, which has supported bank profitability in this particular segment. This is probably how banks have marked-to-market gains in the book, awaiting to be recognised, which will provide cushion for lower NIM.

A research has shown that based on data used from 113 large banks in 14 advanced economies, it was discovered that each 1% decline in policy rate is associated with an increase in income from fees and commission of 0.93%. This shows that even with Central Banks cutting interest rates, resulting in decline in NIM and interest income, banks will double down its efforts to grow its non-interest income. Overall profitability might not be significantly impacted by the interest rates cut.


Low interest rate environment is not only the headwind faced by the banks now, in this section, we will discuss two other headwinds – Digital Banks Threats and Credit Costs – that might affect investors’ decision in initiating a position in a bank. 

Digital Banks Threats

MAS in 2019 announced that it would issue up to five digital banking licenses to non-bank players. Of these, up to two of the licenses will be for digital retail banking, which allows firms to provide a range of financial services as well as take deposits from customers. The remaining three will be  issued for digital wholesale banking, allowing licensees to serve SME and other non-retail sectors. This announcement has attracted a lot of interest where MAS received 21 applications and it was recently announced 14 of the 21 applicants will be eligible for the next stage of assessment. No matter what, the banking space will definitely be disrupted by such applicants by the end of the year, it is only how many applicants will be successful that we should be concerned about. 

DBS was asked about the threat from digital banks and their views on it during the latest AGM. It is no doubt that new entrants will increase competitive intensity and how these new entrants disrupting the markets should not be underestimated since it is free from the burden of legacy and having access to large resources. However, DBS believed that it will not be easy for the new entrants to be successful in the short or medium term. 

The market size of the industry is not big and banking penetration is high at more than 98%. There are no obvious underserved segments, even if there is, TAM for this segment will likely be small. Incumbents have been improving their digital capabilities and offerings for the past few years that the bank believes that it will be an uphill task for new entrants to create very differentiated offerings. 

In addition to having a small revenue pool, incumbent believes that it is impossible that investors backing such businesses would be able to burn unlimited cash competing with incumbents and not having sight of positive EBITDA and returns. Incumbents are heartened that predatory pricing is not supported by the regulators. Having a “winner takes all” mentality has led to industry instability such as in ride hailing and such instability is not healthy in the financial sector. Therefore, incumbents are confident that they will hold their own as Singapore’s banking market is well served by more than 200 players, having additional 5 entrants should be manageable.

Loan and its quality

For interest income to continue to grow, there are two factors to look out for – loan volume growth and NIM. When both factors are in favour, we will see a greater positive impact to interest income. When only one factor is in favour –  loan volume growth in this case, it is whether the loan volume growth can offset the decline in NIM in the coming quarters. 

Banks believe that growth in loan volume, albeit at a slower pace, should be sustainable since that companies will have to draw down lines to ensure sufficient liquidity and that industries benefiting from the current environment continue to draw down loans to expand their businesses. However, trade loan volume is expected to decline since The World Trade Organisation has guided a fall in trade volumes of between 13% and 32%. This should not have a major impact for banks especially for DBS as trade margins are normally thin, impact to net interest income is manageable. Banks are expecting consumer loans growth to be muted in the coming year and also foreseeing other consumer loans such as consumer loans to decline. 

In my opinion, having little to no growth or even slight dip in growth in loans should be acceptable by many investors. Many are really concerned about loan quality and how it might translate to even higher credit costs which will have a negative impact to net profit. We will explore how prudent banks are in managing such uncertainty and whether credit costs estimation will change for the worse.  

Provisions or allowances for potential bad debts are always set aside every financial quarter for banks. In recent quarters, banks have been shoring up more allowances to prepare for the storm. Banks estimate that their credit costs will be from 80 to 130bp cumulatively over two years. Reason for having this time period is that loans under moratoriums this year will only show stress next year. For now, banks do not see any new uncertainties that could cause them to reassess the estimation of credit costs. Even so, for the sake of prudence, for instance, DBS has increased general allowances, taking their GP reserves to $3.8 billion. It estimates that its credit costs will be between $3-5 billion over two years and having taken just under $2 billion in the first half of the financial year, they have set aside substantial portion and will continue to build up allowances in the coming quarters as a prudential measure.

As reported by some analysts in their research, about 5%/10%/16% of DBS/OCBC/UOB total loans are under moratorium, in which a significant percentage of loans are mostly secured against properties. Banks stressed that they are well-secured with relatively low LTVs and some banks are confident that they will not become NPL at the end of the year. However, no one is able to predict what will happen in the future, thus banks are building up substantial general allowances ahead of time to prepare for this uncertainty. 

The key takeaway that DBS CEO would like to put across is that the bank has become more prudent than before. Therefore, it expects credit costs to be in the same range as 2008-09 global financial crisis and the 2002-3 recession, even though the current economic environment is worse. This is because DBS has strengthened credit management and risk acceptance criteria over the years. Thus, it is reasonable to expect similar credit costs even if the current economic situation is worse. 

With that, I believe that banks are more prudent than before. Take for example, DBS, which had in the past extended mortgages to clients at more than 100% LTV. We do not see such high LTV from current loans under moratoriums. For the next few quarters,  net profit after allowances should still be under pressure as banks continue to shore up its provisions for future uncertainties. As moratoriums are secured by collateral and that stress test scenarios are too stringent, I expect credit costs estimation by banks to be unchanged. I believe that if the situation improves in the coming quarters, provisions should be tapered off slightly.

Closing Thoughts

Investors looking to initiate positions in banks should look at the headwinds presented in this article and to evaluate whether one is able to take up the ongoing headwinds. 

I believe that judging based on the confidence level in a bank CEO will paint a better picture of what it is going to be for the coming years. For instance, DBS CEO in its latest earning call mentioned that without MAS’ guidance, they would have been able to maintain the dividend, on the condition that the situation does not worsen beyond what they have anticipated. They even have the capacity to raise dividends next year if the situation improves from now. 

In a value investor point of view, banks are now undervalued and if one is willing to ride out the storm, it is perfectly fine to have banks in their portfolio. This is because it is a heavy regulated business and banks are more prudent than before. However, being overly concentrated in one sector in general is not fine.

Considering this fact, I am quite overweight in banks and therefore, I will not be averaging down for the second time even if it presents an opportunity for me to average down.

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3 thoughts on “Low Interest Rate Environment – Should You Still Buy Banks?

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