For many years the banks groaned under zero and minus interest rates. The share price performance was correspondingly weak. Now that interest rates are rising again, the trend should actually be reversed. But the Deutsche Bank share (WKN: 514000) plunges to new lows instead. How can this be?
Why rising interest rates support banks
The traditional core business of banks is to exploit interest rate differentials. For example, underpinned by customer deposits, you can obtain money at favorable interest rates in the short term. This can be given as a long-term loan at higher interest rates or put into higher-yielding bonds.
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Banks are considered particularly sensitive to interest rates. Zero interest rates spoil business. In a 2018 report on the health of banks, the Bundesbank writes the following:
"The net interest margins earned by banks, which are a crucial part of their profitability, can come under pressure during prolonged periods of expansionary monetary policy and low interest rates."
Consequently, a normalization of the interest rate environment would be absolutely desirable for banks in the long run in order to better benefit from the so-called maturity transformation.
Why Deutsche Bank nevertheless does not benefit
In the short term, however, rising interest rates aren't doing much good. Because the Bundesbank also points out another phenomenon in the next sentence:
"… At the same time, low interest rates can also have a positive impact on profitability, for example, via declining provisioning expenses, but these may not be strong enough to offset declining net interest margins."
Conversely, this means that banks must now increase their risk provisions again. Loan customers usually have no problems making their debt service at mini-interest rates. But if a refinancing at worse conditions is pending in the future, then it can quickly become critical. Variable interest rates strike immediately.
Since it is foreseeable that the number of bankruptcies will increase. And that would cut into the profits of one of the world's biggest lenders like Deutsche Bank. The first quarter already saw an increase in the allowance for losses on loans and advances from. Euro to record. This is now likely to continue throughout the year.
In addition, it must be taken into account that the banks have adjusted to permanently low interest rates. Surprises on the interest front are not wanted there for another reason, as a paragraph from the 2019 management report of Commerzbank (WKN: CBK100) points out:
"An unexpected economic downturn and abruptly rising risk premiums would result in significant losses from bad debts and could hit the banking sector hard. In addition, there are noticeable risks from abruptly rising interest rates in this country. This is due to the expansion of maturity transformation that banks have undertaken in order to stabilize their earnings in the interest business. For example, nearly half of the new residential loans issued in 2019 have fixed-interest periods of more than ten years."
So all in all, the difficult market environment, consisting of supply chain chaos, inflation and rising interest rates, is anything but a welcome development for a financial group like Deutsche Bank.
What the future holds
In the end there are two positive and one negative scenario. If it soon becomes apparent that the chaos in the supply chains and the inflation spook will come to an end, then the risks will also recede and Deutsche Bank can once again focus on increasing its profitability.
Slowly rising interest rates could also have a positive impact by increasing margins on loans. On the other hand, it would be bad if a double blow were to wipe out the recent progress: rapidly rising interest rates, which on the one hand would catch Deutsche Bank's capital management on the wrong foot and on the other hand would put many customers in payment difficulties.
I assume that the first scenario will prevail. The main reason for my optimism is that there is simply far too much to do to meet the challenges of the future. In this case, the cooling economy would land softly, which would be a price driver for a substance share like Deutsche Bank.
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Ralf Anders does not own any of the shares mentioned. The Motley Fool does not own any of the stocks mentioned above.