Why are ASX 200 bank shares plunging on Wednesday?

Banks can increase their lending margins amid higher rates, but they could see negative impacts on the quality of their loan books.

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Key points

  • ASX 200 banks are down sharply today 
  • Higher interest rates do increase the banks' net interest margins 
  • But with the RBA moving aggressively to raise rates, the banks’ own funding costs increase alongside a likely falling housing market 

S&P/ASX 200 Index (ASX: XJO) bank shares are all deep in the red in late morning trade, following on yesterday's 0.50% cash rate increase by the RBA.

The higher than expected hike takes the official cash rate to 0.85%. And governor Philip Lowe indicated Australians should expect more increases from the central bank in the months ahead.

While the ASX 200 is up 0.8% at the time of writing, the S&P/ASX 200 Financials Index (ASX: XFJ) is down 12%. And the ASX 200 banks are underperforming the Financials Index.

At the time of writing the Commonwealth Bank of Australia (ASX: CBA) share price is down 3.5%.

The Australia and New Zealand Banking Group Ltd (ASX: ANZ) share price is down 2.4%.

Westpac Banking Corp (ASX: WBC) shares are down 5.3% after the bank became the first to pass on the full RBA rate hike to mortgage holders this morning.

And the National Australia Bank Ltd. (ASX: NAB) share price is down 3.3%.

Financial stocks, as you've likely heard, can benefit from a higher rate environment.

So, why are the ASX 200 bank shares under pressure today?

Tailwinds from rising interest rates

On the plus side of the central bank's tightening cycle, ASX 200 bank shares have the potential to increase their profit margins amid higher interest rates.

CBA CEO Matt Comyn reported that every 0.25% increase in the benchmark cash rate increases the bank's net interest margins by 0.04%. "That's purely just on the deposit side, and then of course there's offsetting factors from funding," he said.

According to Credit Suisse bank analyst Jarrod Martin (quoted by The Australian):

Net interest margins will get close to 2% from their current level of less than 1.9%. So the balance at the moment favours the upside, but the latter stages (of the cycle) are not as good for bank share prices because of asset-quality considerations, such as the impact on house prices.

So,  ASX 200 bank shares are looking at potentially significantly higher profit margins on the loans they make.

But both Comyn and Martin also alluded to some headwinds.

Headwinds for the ASX 200 bank shares from fast rising rates

As Comyn pointed out, one of the factors that will drag on ASX 200 bank shares' profitability as rates go higher is that their own funding costs increase as well.

And as Martin said, the looming impact on housing prices is also something investors will be keeping a close eye on.

Morgan Stanley's head of Australian research, Richard Wiles, said that ASX 200 bank shares were likely to perform worse if the RBA moves to increase the cash rate rapidly.

According to Wiles (quoted by The Australian Financial Review):

Much of the benefit of higher rates is factored into the outlook. Housing loan growth is likely to slow, inflation is putting more pressure on costs, and a quick and aggressive tightening cycle increases tail risks.

We believe the near-term earnings outlook remains sound, but the risk of a trading multiple de-rating has risen.

Andrew Triggs, executive director at J. P. Morgan also pointed to the mixed impacts of higher rates on ASX 200 bank shares (courtesy of The Australian).

"Cash rate hikes off record lows should lead to modest net interest margin expansion, but faster rate hikes raise concerns about credit growth slowdown and asset quality deterioration," he said. "Banks report significant home loan buffers, but there is a large cohort of borrowers that has never seen rate hikes before."

ASX 200 bank shares tend to underperform when house prices are falling.

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 recommended Westpac Banking Corporation. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Scott Phillips.

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