Profitability Paradigm : Margin Compression - The P & L Story

Since the last post, other banker friends joined the conversation of shrunken transactions and the resultant Margin compression. As I said in the first blog, the trigger was a sizeable fall in the transactions (both in volumes & value) of the banks. (https://www.finextra.com/blogposting/18844/profitability-paradigm-moving-from-business-continuity-to-protecting-margins-to-growing-p-amp-l)

The transaction volumes dropped by 30% plus in the first half of this year. A deeper analysis shows a steeper and more dramatic drop in  branch transactions, almost 60% to 70% - not surprising, given the Pandemic. There has been a fall in digital transactions too  (a much lesser degree though), as  customers limit their transactions to essential minimum. The objective here is to look at the impact of shrunken transactions on Margins.

Setting the context,  transactions can be financial and non-financial. It is the financial transactions that have a direct bearing on the margins. Broadly, financial transactions can be categorized into deposits, withdrawals, transfers, payments (loans, utilities) or purchases of third-party products (insurance, Mutual funds). Transactions of all these categories, except the last one (which interestingly is leading the reverse trend), have shrunken and bear a direct impact on bank’s net income.

At a fundamental level the two big blocks of income for banks are Net Interest Income (NII) and Net Non-Interest Income (NNII). First a look at  Net Interest Income which is derived as Interest Income - Interest Expense.   

Effect on Interest Income – Reduction (Due to reduction in payments). Fall in interest income from individuals and /or businesses is of three types

a) Unable to pay

b)Under able to pay 

c)Breakage/ foreclosure of higher interest mortgages and rebooking them at lower rates  (Taking advantage of the lower interest rates)

Effect on Interest Expense – Not material as banks must pay the interest committed on their liabilities.  (Except in the case of banks having a sizeable portfolio of liabilities on floating rate basis)

Net effect – Fall in Net Interest income as there is a fall in interest income with no complementary fall in interest expense (Not considering the interest income from investments and interest expenses for borrowings  as both are equally affected by market and therefore  likely to cancel off each other with minimal net effect, unless banks are skewed one side or the other)

Before I go to the effect on Net Non-Interest income, a relevant data point is that Non-Interest income is almost a third of a bank’s total income and hence a focus for bankers. My banker friends agree saying the increased focus on this component over years has been because this source was less volatile & less subject to market vagaries.

An analysis of US Commercial Banks reported that in 2018, the Non-Interest Income was about $255 million equal to 41.69% of  Interest Income and 29.42% of total income.

Effect on Non-Interest Income – Reduction. This is due to reduction in all classes of fee bearing transactions  like remittances, charges for loan origination, processing & servicing, credit card maintenance, foreclosure, insufficient funds, fees for off-balance sheet activities, charges for forex operations etc. The negative impact is not only because of fall in transactions but also due to regulatory guidance or voluntary moratoriums by individual banks (given to support customers during the pandemic) of non-charging for late payments , non-payments, remittances etc.

Commission on third party products  -One area that could be a silver lining for banks that distribute Insurance (Health & Life) products is an increase in demand for these. Forbes reported that, starting January 2020 online life insurance sales increased by 30% to 40%. National association of Insurance commissioners reported that the surge in the potential Life Insurance demand could replicate the 78.9% surge in 1919 following the Spanish Flu.

What this spike means to insurance Industry – well that is a separate conversation.

Effect on Non-Interest Expense – Not material- As all fixed costs like rentals, leases, salaries, IT costs, maintenance etc. continue as they are fixed operating costs of running the banking business.

Net effect – Fall in Net Non -Interest income as there is a fall in non-interest income with no complimentary fall in non-interest expenses.

Credit Losses – Rise. This is third block that affects Net Income. Write off, of the actual credit losses impacted by the environmental factors. At this point am not talking yet of the impact on provisions required by regulators say for IFRS 9.

Net effect of shrinking financial transactions, with reduction in Net Interest Income & Net Non-interest Income and a rise in credit losses is a sizeable margin compression leading to a stress on the P&L book of the banks. What caught banks in a tough place was velocity of impact.

Retail spending is down and businesses, both SMEs & Corporates, are holding off investments and expansion plans for now as they struggle to find a balance in the new normal. The result is higher volumes of cash and liquid deposits like savings & checking with the banks. Usually a welcome situation as banks can lend/ invest these for higher yields. But the current environment is unfamiliar where the “New Next” has put the balance sheet & cash flows too under stress. Will explore the impact on Balance Sheet, provisions and capital in next blog.

Next Blog – “Capital and Reserves Compression –The  Balance Sheet Story”