Our ASX bank shares have had something of a renaissance in 2019 so far. With the Royal Commission firmly in the rear-view mirror, investors have taken the banks on their word that 'they will do better' and rewarded them with an influx of new capital.
To illustrate – the National Australia Bank Ltd (ASX: NAB) share price has risen 13% year-to-date, despite NAB losing its CEO and chairman on the back of the company being singled out by Commissioner Kenneth Hayne for both serious and serial misconduct.
Are the banks out of the woods?
Long story short, investors have been quick to forgive the banks after it has become clear that long-term profitability wouldn't be too severely compromised. But 2019 might prove to be an equally concerning year (profit-wise) for a different reason – interest rates. As we all know, interest rates have been cut by the Reserve Bank of Australia (RBA) twice in the last two months, with the very real possibility of a further cut or two by this time next year. This would take the cash rate to a new all-time low of 0.50%.
Why does this affect profitability?
When interest rates were cut by 0.25% last week, the rates that banks like NAB and Westpac Banking Corp (ASX: WBC) charge on mortgages and loans instantly become 0.25% more profitable. The problem for the banks is that there is significant pressure to pass on the full cut to their customers, both from the Government and from intra-bank competition.
Under normal circumstances, the banks would recoup these costs by cutting the interest rate they would normally pay for a term-deposit or savings account accordingly. But interest rates are now at levels where it becomes difficult to cut these rates any further as they are already approaching zero – for savers, we are at the end of the line. If rates are cut any further, banks are going to have to choose between keeping their customers happy by passing on the rate cuts for mortgages and keeping shareholders happy by not digging out of earnings to fund said cuts. It's a rock-and-a-hard-place situation, and one that could take a chunk out of the banks' share prices if rates stay low.
Foolish takeaway
It's hard to predict what the future may hold, but on current trends, I personally don't think the immediate future is too rosy for our banks. The RBA has indicated an easing bias going forward, and this will continue to squeeze bank shares if it eventuates.
