5 ways to respond to margin compression for UK Retail Banks

11 November 2016

By Yousef Ghazi-Tabatabai

Despite the recent steepening of the UK gilt curve and increasing inflation expectations, the “lower for longer” interest rate environment remains a concern for UK retail banks. The Bank of England’s November inflation report raises inflation expectations “largely as a result of the depreciation of sterling”, seeing the Consumer Price Index reaching 2.75% in 2018 and falling to “close to the target” over the following couple of years. Given the comments regarding inflation tolerance in the report, banks should consider a “lower for longer” scenario to continue.

“Given the projected rise in unemployment, together with the risks around activity and inflation, and the potential for further volatility in asset prices, the MPC judges it appropriate to accommodate a period of above-target inflation”  - November Inflation Report, Bank of England

Retail banks face margin compression as the (real or perceived) zero rates floor on liabilities is at odds with a desire to provide competitive pricing for assets. This problem will only grow with time, as fixed rate assets (including some mortgages & loans) reprice at the prevailing rates.

A strategic response to margin compression

Responding to margin compression requires a strategic approach tailored to a bank’s business model. We suggest that banks consider the following actions:

Create cost transparency through an appropriate funds transfer pricing process which correctly allocates central costs (such as funding and regulatory costs) down to the product level. Without this a bank will be unable to assess product or client profitability, and may create counterproductive incentives for its business units.

Find the sweet spot on the curve, taking into account the recent steepening and the bank’s views on future curve movements. Extending asset duration takes advantage of the higher rates, however this is balanced by increasing funding costs, liquidity risks and price sensitivity.

Regain pricing power through an analysis of client profitability versus price sensitivity at the product level, enriched by an analysis of the bank’s key client relationships, and peer comparison.

Review the hedging strategy to ensure it optimally reflects the rates environment, the bank’s expectations and the risk appetite. Be prepared for a variety of rates outcomes, and include negative rates scenarios in stress tests.

Optimise the business mix at a variety of levels. For example, optimisation at a high level may lead to a rebalancing between different types of lending (e.g. credit cards and mortgages) or customer. Greater cost transparency, changes in pricing, duration and hedging may all impact the optimal business mix, which should then be reviewed following the steps above.

To succeed, the response must be tailored to a bank’s business model, and given the existing structure of their balance sheets and their strategic priorities different banks may find that pricing power reviews and optimisation leading to different answers.

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