On balance, decisions this month by the US Federal Reserve and the Bank of England to slash interest rates in order to help prop up their respective economies in the face of slowing growth – and the threat of a recession due to the spread of coronavirus – are bad news for the banking sector.

While on the one hand interest rate cuts and fiscal stimulus may help avoid a flood of corporate bankruptcies and an increase in bad loans, on the other hand it makes it a great deal harder for banks to generate a profit on lending.

Banks are likely to be encouraged by governments to make loans to businesses who don’t want them or can’t afford them, on a margin where they can’t make any money. Banks then won’t be allowed to pull the plug if or when the loan goes sour.

In the US, mortgage refinancing applications surged 80% in the week following the Fed’s ‘emergency’ 0.5% interest rate cut, which is great news for the economy but bad news for banks. It has since cut rates even more.

Refinancing by its nature doesn’t generate additional revenues – just the reverse in fact. Homeowners are renegotiating their mortgages on a lower interest rate which for the banks means a lower revenue stream from the same customer base.

In the UK, banks are already struggling with net interest margins – the difference between the interest rate they can charge on loans and the rate they pay out on deposits – as low as 1.5%, largely due to fierce competition for new mortgage lending. A 0.5% cut in interest rates is a bitter blow to their hopes of increasing their profitability.

We selected Lloyds (LLOY) as one of our top picks for 2020; sadly the dramatic cut in interest rates changes the investment case. It is going to be a long slog to recover the recent share price losses and under the circumstances we are no longer bullish about the stock.

Another threat to banks, according to ratings agency Standard & Poors, is a weakening of their loan book quality as the effect of coronavirus will reduce global travel and factory output, dampening demand.

That view is echoed by Scope Ratings which says that ‘asset quality deterioration seems likely’ if European governments respond to the coronavirus threat with ‘draconian measures that undermine growth’, a scenario which it views as increasingly likely.

Marco Troiano, deputy head of the financial institutions team, adds: ‘Slower volume growth, lower investment banking revenues and higher loan defaults should all be anticipated at this point.’

‹ Previous2020-03-19Next ›