S&P/ASX 200 Index (ASX: XJO) bank shares are an interesting investment proposition. The question is: Are bank shares a no-brainer buy right now in this time of high inflation?
Now is a busy period for the banking sector because it's reporting time for three of the big four banks: Australia and New Zealand Banking Group Ltd (ASX: ANZ), Westpac Banking Corp (ASX: WBC) and National Australia Bank Ltd (ASX: NAB).
We've already heard the earnings results from ANZ, Westpac has reported today and NAB is expected to report on 9 November. Commonwealth Bank of Australia (ASX: CBA) has a reporting period that ends in June, which is then reported in August.
Let's take a look at where inflation comes into the banking equation.
What's going on in the banking world with inflation?
Inflation measures the prices of a broad range of products and services.
The Australian Bureau of Statistics (ABS) recently released the quarterly inflation numbers for the period ending September 2022.
For the three months to September 2022, the consumer price index (CPI) rose 1.8% for the quarter. Over the 12 months to September 2022, the CPI rose 7.3%, according to the ABS.
It was revealed that the most significant price rises were within new dwelling purchases (3.7%), gas and other household fuels (10.9%) and furniture (6.6%).
In terms of the bank's costs, we have seen that ANZ reported that its total expenses to run the bank were flat. Of the total $9.17 billion cash expenses, it saw a cost uplift of $289 million, but then productivity gains saved $261 million.
But, ANZ did say that expense trends "will be impacted by headwinds arising from wage and vendor cost inflation". It's expecting its FY23 expenses to increase by around 5%, though it anticipates revenue growth to be higher than cost growth.
Turning to what Westpac said today, the bank reported that its total expenses were down 7% to $10.8 billion, excluding notable items. While ongoing expenses increased by $11 million, Westpac is working on reducing its current cost base.
Interest rates
ASX 200 bank shares generate most of their profit from lending. So, inflation itself doesn't necessarily improve profitability for the banks.
However, in the RBA's words, inflation is "too high". The RBA has significantly increased interest rates since May, a necessary evil "to establish a more sustainable balance of demand and supply in the Australian economy to help return inflation to target".
Despite increasing the cash rate target by 25 basis points to 2.85%, the RBA said it expected to "increase interest rates further over the period ahead".
A higher interest rate is having the effect of boosting the ASX 200 bank shares' net interest margins (NIM). This measures how much profit banks are making on their loans. It compares the lending rate against the cost of that lending (such as savings accounts and term deposits).
In the first half of FY22, ANZ's NIM was 1.58%. In the second half of FY22, this had risen to 1.68%. The exit margin for September 2022 was 1.8%. According to the bank, it could earn over $3 billion more profit in FY25 compared to FY22 thanks to higher interest rates.
Westpac also reported that its underlying NIM improved by 10 basis points from 1.7% in the first half of FY22 to 1.8% in the second half of FY22.
Foolish takeaway
While banks are gaining a tailwind from the rising interest rates, it's not extra profit with no risk. Can households afford to pay hundreds – or thousands – of dollars more a month in loan repayments (plus everything else that has risen in price)?
Dividends from the ASX 200 bank shares may grow, but I'm keeping an eye on how loans in arrears may increase as these challenging economic times take their toll on borrowers.
