UK banks will start to feel the cost of interest rate hikes as the Bank of England steps up efforts to fight persistent inflation.
The Bank of England's Monetary Policy Committee (MPC) surprised markets on June 22, increasing the base rate by a larger-than-expected 50 basis points to 5%. The MPC said there are "significant" indications in recent data that inflationary pressures on the UK economy will remain for longer than expected.
Higher rates will pressure borrower affordability, leading to more loan losses, analysts said. Banks will also have to tackle rising deposit costs as they pass on a greater share of rate hikes to customers, while a slowdown in lending, especially across mortgage books, will add to the headwinds.
"Higher rates lift bank earnings but at a certain level this equation breaks down," Exane BNP Paribas analyst Guy Stebbings said in a June 20 research note. "We are well past this point."
Rate headwinds
UK inflation remained at 8.7% in May, above the 6.1% in the eurozone and 4% in the US. BoE governor Andrew Bailey said the central bank will do whatever is necessary to reduce inflation, triggering a change in market expectations for the peak BoE base rate.
"[T]here is more tightening to come. We now look for a peak in September at 5.75%," Dean Turner, chief eurozone and UK economist at UBS Global Wealth Management, said in a June 23 note.
Higher net interest income (NII) will be an immediate impact of further rate rises, and this is a key driver of bank profitability. Yet, headwinds to NII growth are growing stronger.
"The NII upside at this point in the cycle is more limited than it was in full year 2022," said William Edwards, associate director at S&P Global Ratings.
Structural hedges, used by banks to limit the impact of short-term rate hikes on their balance sheets, are larger than ever, but the pass-through of higher interest rates to depositors has also increased, Edwards said. There was also a strong shift to term deposits in the first quarter of 2023 as customers sought higher-rate products.
NII at the UK's largest banks has increased over the past five quarters, but the pace of growth slowed in the first three months of 2023, S&P Global Market Intelligence data shows. A similar trend emerged in the development of net interest margins (NIM), which measure the difference between the interest banks earn on loans and pay on deposits.
UK-focused lenders NatWest Group PLC and Lloyds Banking Group PLC kept their respective 2023 revenue and NIM targets unchanged after first-quarter earnings, given expected rate-related headwinds.
Lloyds' NIM will be pressured by deposit and mortgage book repricing, as well as rising competition among lenders, as savers switch to higher-rate deposit products, CFO William Chalmers said on the bank's first-quarter earnings call. NatWest's CFO, Katie Murray, said on its earnings call that the bank's ability to benefit from higher interest rates declined over the first quarter as liquid and interest-earning assets fell.
NII outlook still positive
Most banks maintain a much lower BoE rate of 4% to 4.25% in their assumptions for 2023. Analysts have been disappointed with the banks' 2023 guidance so far.
Ratings now expects UK bank NIMs to peak later than anticipated, Edwards said. For the larger UK banks, it is likely to come in the fourth quarter of 2023 or first quarter of 2024, instead of the second or third quarter of 2023 as previously assumed, Edwards said.
Current mean consensus estimates on an annual basis point to a 2023 NIM peak for most large UK banks, with continued NII growth in 2024 and 2025, Market Intelligence data shows.
Mortgage pain
Rising rates will negatively impact banks' asset quality. Credit losses are likely to rise nearer to historic averages, according to Richard Barnes, senior credit analyst at S&P Ratings.
"It would be surprising if the asset quality picture remains so benign given the rise in borrowing costs, which squeeze the affordability of corporate and household borrowers," said Barnes.
The UK has a relatively short-term mortgage market where products mature every three to four years on average. As of June 23, the average rate on a two-year fixed mortgage was 6.19%, compared to 2.34% at the end of 2021, according to data by UK comparison site Moneyfacts.
"Refinancing at current mortgage rate levels is quite a payment shock for borrowers," said Barnes.
Debt service ratios, which measure the size of debt repayments to available income, are expected to exceed global financial crisis levels and the stock of mortgage lending is likely to contract in 2023, Exane's Stebbings said. Bank earnings will be hit by growing "mortgage spread challenges, exaggerated by weak volumes," said Stebbings.
Executives at some of the largest UK retail banks, including Lloyds Banking Group and NatWest, agreed to a 12-month delay on home repossessions at a June 23 meeting with UK Chancellor Jeremy Hunt. The meeting was called by Hunt to ensure banks will stick to their previous commitment to help vulnerable clients who are struggling to make mortgage repayments.
HSBC declined to comment, while Barclays, Lloyds and NatWest did not respond to requests for comment.