Would rate hike necessarily widen NIM?

• With Bank of England already ahead, the US Fed is expected to raise interest rates as soon as during its March policy review
• While higher rates are generally good for banking sector NIMs, they may in practice contract, especially if rates on deposits increased faster than those on loans
• The argument for NIMs to  increase when central banks tighten rates remains open

As the Federal Reserve Bank (Fed) talks about raising rates this year, what impact will it have on bank net interest margins (NIMs) will be widely discussed. The Fed has been holding the funds rate (primary credit rate) at 0.25% since late 2018. In light of ongoing inflationary pressures and improvement in labour market conditions, the Fed may soon deem appropriate to “begin a process of removing policy accommodation”. This also includes reduction in balance sheet expansion as it scales back monthly bond purchases. Across the Atlantic, Bank of England increased the base rate for the first time in three years from 0.1% to 0.25% to control surging inflation.

The argument for raising rates to induce higher interest margins holds mainly in the context of zero lower bound on nominal rates. Banks target the spread between rates on assets and liabilities. In the US, since zero lower bound has been effective since early 2008, NIMs have generally been narrower as naturally, banks cannot push rates on deposits/liabilities below zero. The rates on loans (though higher than deposits) have also been low.

However, as Fed raises rates, banks may raise rates on deposits more slowly than loan rates, widening the NIMs. This idea is generally widely accepted in markets where banks possess more power to pay less on deposits relative to charging higher interest on loans. Obviously a depositor would be less likely to switch banks than a borrower when rates are moving up than the other way around.

While in theory, a steady rise in interest rates is broadly positive for banks’ net interest income (NII), and an increase in loan rates, following a central bank hike could boost NIMs, the statement should be taken with a pinch of salt. On the contrary, NIMs may even collapse after rates are raised. The maturity of assets versus liabilities is more likely to impact margins. For instance, liabilities such as business deposits which have relatively short-term maturities and are more interest rate sensitive in contrast to assets such as business loans which have longer-term maturities. As short-term rates track policy rates more closely, and if policy rate increases, banks would pay out more in interest on deposits while rates on long-term loans would remain stable or change little, effectively narrowing NIMs. A real-world case could be traced back to early the 1980s when Fed raised rate during its anti-inflation campaign. The interest paid to depositors increased significantly while rates earned on their portfolios of mortgages changed little, collapsing NIMs.

Therefore, the argument for NIMs to increase when central banks tighten rates remains open.