Rising interest rates are great for bank margins, right? Yes, but too much of a good thing could backfire.
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If you’ve been keeping up with the share markets in recent months, you’ll already know the banks have done very well.
Banks and the miners have carried the S&P/ASX 200 Index (ASX: XJO), often dragging it back to moderate losses on days when other sectors have burned to the ground.
In fact, since the COVID-19 Omicron variant reared its head in late November, the S&P/ASX 200 Financials (ASX: XFJ) has gained more than 5.5% while the ASX 200 has lost 0.5%.
And with the Reserve Bank raising the cash rate last week, and expected to do so again multiple times this year, banks have plenty of reason to cheer.
So, as investors, is it too late to jump on the banking bandwagon? Are those shares worth buying now?
Switzer Financial director Paul Rickard, who made his name once as an executive at Commonwealth Bank of Australia (ASX: CBA), answered this question.
‘Most of the run is behind them’
Rickard told Switzer TV Investing that it’s not too late to buy big bank shares, but only if you set your expectations low.
“I think the best and most of the run is behind them,” he said.
“Sure, they’re going to win from higher interest rates now… That’s going to effectively allow them to improve their so-called ‘net interest margin’.”
Net interest margin is the difference between the lending interest rate (income for the bank) and the deposit interest rate (expense for the bank).
Australian banks often benefit from cash rate rises because they immediately pass on the full effect to borrowers but forward very little, if at all, to deposit holders.
So this expands their net interest margin.
Too much of a good thing could make one vomit
This scenario seems like a simple win for the banks, but Rickard warns that repeated rate rises could backfire.
“What people have got to be careful of is ultimately higher interest rates slow the economy down. They slow borrowing demand down, which makes volume growth harder,” he said.
“Then in the longer term, if [rates] stay high for a long term, borrowers find it harder to repay.”
Right now, according to Rickard, the big banks are in the best position in years in regard to bad debts and loan defaults.
This is because of the combination of historically low rates and generous COVID-19 provisions.
“Banks have been huge winners of over-providing in COVID-19 and writing it back,” said Rickard.
So all this means is that the bad debt total can only get worse from here for all financial institutions.
You won’t get another $18 rise
Rickard advised that if investors buy into bank shares now, they need to expect significantly less return than the spectacular rises seen in the past year or two.
“National Australia Bank, to give some context here, was $14 in March 2020… and today it’s $32,” he said.
“I don’t think [investors] are going to get another $18 out of them.”
The best shareholders could hope for from here is single-digit gains, according to Rickard.
“Mainly because they are struggling still to grow revenue and that’s still their fundamental problem.”
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Motley Fool contributor Tony Yoo has no position in any of the stocks mentioned. The Motley Fool Australia’s parent company Motley Fool Holdings Inc. has no position in any of the stocks mentioned. The Motley Fool Australia has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Scott Phillips.