Banks have been waiting years for a rising interest rate environment to boost revenues and margins. That time has finally come. Just not how they expected.

The Bank of England base rate is already up from 0.25 per cent at the start of the year to 2.25 per cent. Since Kwasi Kwarteng’s “fiscal event” last Friday, markets have been betting it could hit 6 per cent next year.

This should be a bonanza for the big banks. Analysts are overwhelmingly positive. Investors, however, are not.

The benefit to Britain’s large high street lenders from higher interest rates is plain enough. Rate rises are passed on in full to borrowers, but only around half the benefit flows through to savers. Up until the most recent interest rate increases, banks had been passing on more like 20 to 30 per cent of the benefit to depositors. For Lloyds Banking Group, each 0.25 percentage point rise adds around another £175mn to net interest income. When interest rate expectations have risen by as much as 2 percentage points in a matter of weeks, that means a substantial improvement in profits.

For the sector, UBS analysts reckon every 0.5 percentage point upwards move of the rate curve adds something like 3 to 4 per cent to pre-provision profits. The cumulative effect of the recent change in expectations could add anything from 10-20 per cent to pre-provision profits even based on cautious assumptions about the proportion of higher rates passed on to depositors, Jason Napier of UBS noted earlier this week.

There is of course the risk that loan growth could slow. But, according to Napier, even if loan growth were to disappear that would hit sector earnings by only around 2 to 3 per cent. Banks already hold large books of mortgage debt with a low rate of churn.

Yet bank shares have slumped over the past two weeks. The disconnect between analyst euphoria and investor gloominess is, of course, over provisions.

The big three UK-focused banks — Barclays, Lloyds and NatWest — will have to update their forecasts of expected credit losses when they report third-quarter results in four weeks’ time. The rise in mortgage rates means that (notwithstanding government support for energy bills), there will probably be downgrades to the growth outlook and increases to expected loan losses even if the point at which households are unable to pay their mortgage debt is years away.

Banks have gone into this downturn far better capitalised than in the past. The knock-on effect for provisions is complicated by the hangover from Covid, when banks booked big provisions that they haven’t ended up having to use and which could provide a cushion.

On top of that, the expected revenue growth should give the banks greater capacity to take a hit. Jefferies analysts estimated last week that the three banks should increase their revenue by £12bn between 2022 and 2025 as margins expand and assets grow modestly. “That incremental loss-absorbing capacity represents almost the entire cost of credit charges recognised in 2020,” they note. It’s not until the base rate moves above 6 per cent that the estimates of consumer loan loss rates start to shift materially.

But to state the obvious, it is hard to forecast the implications of a disorderly interest rate shock. Even if there is a sharp fall in house prices, what happens to unemployment will probably be more important. Households may remain resilient but the risks to corporate debt could be more complex.

Investors are betting that provisions could have a material impact on 2023 earnings. Credit Suisse estimate a severe recession could take up to 30 per cent off 2023 pre-tax profits if the UK ends up with a 4 per cent decline in GDP akin to the 1980-81 one. A mild recession with a 1.5 per cent drop in GDP puts provisions at more like 5 per cent of pre-tax profit.

The broader question will be about whether higher interest rates stick after the cyclical downturn. Maybe the structural outlook for banks has, finally, improved after years of low interest rates. But it would take a bold investor to back the banks as the UK economy unravels by the day.

cat.rutterpooley@ft.com
@catrutterpooley