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Unlike in the previous rate hike cycle, the significant increase of the key rate in H2 2023 (from 7.5% to 16% per annum) did not lead to a decline in banks’ net interest margin. On the contrary, it even increased slightly in the abovementioned period compared to the second quarter of last year (4.8% in Q3 and Q4 2023 vs. 4.6% in Q2).

This was possible thanks to faster growth of interest income due to an increase in the shares of floating-rate corporate loans in banks’ loan portfolios (from 39% at the start of 2022 to 46% as of July 1, 2023) and preferential loans[1], the profitability of which depends on the key rate of the Bank of Russia, on the backdrop of a growing share of client funds in demand accounts (that are less expensive for banks) by mid-2023.

ACRA notes that the impact of the rate hike on the profitability of banking within the current cycle of monetary policy tightening is different to the one observed during previous cycles.

At the end of 2021, there was a trend toward a smooth decline in the net interest margin on the back of a gradual increase of the key rate (from 4.5% to 8.5% per annum by the end of the year). As a result, by the end of 2021, the cost of attracting time deposits from legal entities and individuals had grown slightly faster than the interest rate on assets. Loan interest rates have historically been less elastic due to the greater maturity of funds placed in most loan segments compared to bank liabilities.

After the sharp increase of the key rate in late February 2022 (from 9.5% to 20% per annum), the net interest margin declined to 2.9% in the second quarter of the year compared to 4.3% as of the end of 2021. This dramatic decline was triggered by external shocks, the result of which the cost of funding in Q2 2022 grew much more than asset profitability (amid a large-scale outflow of client funds, banks were forced to quickly increase deposit rates to levels that matched or even exceeded the key rate, especially for retail clients). Besides the usual reasons related to the maturity of assets, the growth of their profitability in this case was constrained by a transition period imposed by lawmakers, which limited increases of interest rates on corporate loans. At the same time, the margins of banks that were growing retail lending were supported by the Bank of Russia’s easing of restrictions on retail loan interest rates.

It is also worth noting that in the conditions of rapid growth of rates in the economy, banks are resorting to tools to compensate for lost interest income using commission fees in order to reduce emerging gaps in the profitability of assets and liabilities and slightly smooth out the negative effect of the loss of profitability on the financial result.

¹ In particular, the share of mortgage loans issued under preferential programs in Q1 2022 and Q2 2O23 was 34% and 51%, respectively.

Figure 1. The interest margin is more stable

Source: Bank of Russia

The observed trends allow us to, in particular, conclude that the nature and conditions of changes to monetary policy are some of the key factors that determine the dependence of banks’ net interest margin on changes to the key rate.

Unlike 2022, in 2023 the Bank of Russia increased it at a relatively smoother pace and not against the backdrop of external shocks accompanied by an outflow of funds from individuals and legal entities. As a result, banks had more room to maneuver in managing funding costs.

At the same time, the increased profitability of deposits of individuals and legal entities led to an increase in their share in funding sources and, as a result, to a gradual reduction in the gap between the average attraction rates and placement rates of client funds in Q3 and Q4 2023. As a result, there was already a slight decrease (by 0.3 pps) in the banking sector’s net interest margin at the end of Q1 2024.

Figure 2. The impact of a higher key rate on banks’ interest rates was more controlled in 2023

Source: Bank of Russia

modelS matter

Practice shows that the level of the net interest margin largely depends on the chosen development model of a credit institution within its characteristic business areas, its size, as well as the success of management’s actions in implementing the strategy. This premise has been confirmed by ACRA’s analysis of several groups of banks, united according to the characteristic features of various areas of operations — the impact of the 2023 trends on the margins of market participants depended on their business models (ACRA identified universal, corporate and retail banks and separately analyzed foreign subsidiaries of credit institutions).

At the same time, the Agency recorded cases of both small banks with a high level of received interest margin, and relatively low-margin large players. For example, for retail banks there is a clear dependence on the level of risk exposure of credited segments and on the level of innovation and efficiency of products and services. If there is adequate risk control, higher underlying profitability always enhances the ability of banks with this advantage to adapt to pressures on profitability.

In particular, major credit institutions with a universal development model recorded net interest margin growth from 4.4% in Q2 2023 to 4.5% in Q4. The net interest margin in H2 2023 for this sample of banks was 4.5% compared to 4.2% in the first half of the year. At the same time, the margins of these banks grew against the backdrop of a significant increase in the volume of assets generating interest income (about 24% for 2023).

However, ACRA notes that the influence of changes to monetary policy on the profitability of the largest banks varies. This evidences the varying opportunities and differences in approaches to managing interest margin in the operating environment that has formed since early 2022, as well as the presence of assets with limited potential to generate interest income at certain banks.

In general, the largest credit institutions have more opportunities to change price parameters for active and passive operations due to the scale of their influence on the market. However, this factor is not the only determining one.

Figure 3. Net interest margin dynamics by type of bank

Source: ACRA

As for the impact of the development model on net interest income, we can note the difference in the effect of tightening monetary policy on margins.

Banks whose assets are dominated by their corporate loan portfolios have demonstrated rather high sensitivity of their net interest margins to the key rate movements in early 2022. The key rate hike in Q2 2022 resulted, in most cases, in a slight increase in interest income of banks in this group. This was due to the lower prevalence of floating-rate loans, as well as measures to support companies, including a transition period to increase interest rates, credit holidays, and debt restructurings. Combined with the general increase in the cost of funding for the entire market, this led to a significant reduction in the margin of this group of banks both in Q2 2022 and for the whole year. At the same time, it is worth noting that the volume of interest expenses of some banks exceeded their interest income in Q2 2022.

The key rate hike in Q2 2023 showed that credit institutions have worked on the mistakes of the previous year. Almost all corporate banks from the analyzed sample demonstrated higher profitability in the third quarter (up 0.6 pps) thanks to faster adaptation of loan rates, which was facilitated by an increase in the share of floating-rate loans. An important positive aspect was obviously the absence of legislative restrictions on the growth of interest rates on loans.

In Q4 2023, some credit institutions in the corporate segment showed a decrease in net interest income compared to the third quarter. This decrease was driven by faster-than-expected growth of interest expenses as a result of the flow of funds from current accounts to deposits and the inflow of additional funds to deposits due to their increased profitability. However, these net interest income dynamics were observed only by a few financial institutions, and in Q4 2023 it did not impair the overall profitability of this type of banks.

In Q2 2022, the net interest income of retail banks plunged, followed by a corresponding fall of the net interest margin. The reasons for this included a surge in expenses on borrowed funds and lower elasticity of interest income on assets both due to a smaller share of subsidized loans in portfolios and the easing that was in effect at that time, which made it possible to reduce the credit burden on the population.

At the time of the key rate change in Q3 2023, retail banks demonstrated relative stability of the interest margin, which remained virtually unchanged on average among the analyzed sample. This indicator was determined by multidirectional trends. Despite the slower growth in the profitability of retail loans compared to corporate loans, the dynamics of net interest income at most banks contributed to an increase in profitability. However, the growth of the interest income of some credit institutions still lagged behind the growth of their assets. At the same time, one of the sample banks significantly reduced the volume of interest income in Q3 2023 due to the sale of a significant part of the loan portfolio a quarter earlier.

The funding of banks engaged in consumer lending is mainly of a retail nature, so the growth in funding costs was prolonged. In the fourth quarter of last year, the interest expenses of this group of banks increased stronger than in the previous quarter, taking into account the increase in the share of deposits in borrowed funds and a significant increase in the volume of these funds due to new deposits. At the same time, in autumn 2023, the Bank of Russia significantly increased the risk factor allowances for the most high-risk retail loans, which slowed the growth of average lending rates.

At the same time, unlike banks in the corporate segment, almost none of the retail banks showed a decrease in net interest income in the fourth quarter of last year. However, their slight increase in the sample as a whole, on the backdrop of an increase in the base of assets generating interest income, led to a decrease in the average net interest margin for this type of banks in Q4 2023 compared with Q3 2023. The combination of the abovementioned factors consolidated the downward trend in the profitability of retail banks, which decreased by another 0.4 pps in Q1 2024.

The impact of changes in the key rate on the profitability of most subsidiaries of foreign financial institutions deserves special attention. A characteristic feature of the business models of such banks is that a significant portion of their assets are funds deposited in accounts with the Bank of Russia and as part of reverse repurchase transactions with a central counterparty. Due to this, the key rate hike in H2 2023 contributed to a gradual increase in the net interest margin received by these banks, which continued this year (+1.6 pps for Q1 2024). It is worth noting that growth of the net interest margin was also observed during 2022, however, a sharp but short-term jump in the key rate did not have such a strong effect on the increase in the margin of the banks of the group in question in the second quarter, given the more ‘classic’ structure of their assets at that time, without the predominance of funds held in financial institutions. As this structure changed, profitability gradually increased until the end of 2022.

For some banks in this category, it is worth noting a significant margin spread (from 3% to 9% in 2023), which is largely determined by the specifics of the structure of funds raised and the share of equity in liabilities. Some financial institutions had very low interest expenses on client funds during 2023 and 2024. This is often typical for banks with high capitalization and for credit institutions that continue to make client payments abroad, which in itself contributes to the maintenance of clients’ balances at these banks, regardless of the rates charged. At the same time, these banks often have minimal or no funds from individuals in their liabilities, changes in the value of which could put pressure on margins.

inevitability of A DECREASE

ACRA notes that in the current cycle of key rate hikes, despite the average maturity of assets exceeding the maturity of liabilities, interest rate risks have had no significant negative impact on the financial results of banks. The potentially severe impact of these risks was offset primarily by a significant proportion of assets, the profitability of which followed the key rate.

At the same time, according to the Agency’s expectations, after a relatively long period (since Q4 2022) of the banking sector’s net interest margin being in the range of 4.6–4.8%, this indicator will decrease slightly in 2024. Despite a relatively high average key rate projected for the current year, which contributes to maintaining the interest income on assets, we expect a certain additional decline in banks’ profitability, which will be in the range of 4–4.3%. This is close to the values of 2021, when the average annual key rate was significantly lower than in 2022, 2023, and 2024.

The outstripping growth in funding costs at the end of last year and the beginning of this year has already led to a decrease in the profitability of the banking sector in Q1 2024 (it declined to 4.5%). After some stabilization in January to March, the growth in funding costs accelerated and is now again exerting noticeable pressure on the interest margin. In anticipation of a key rate hike and in conditions of increased competition between banks for retail funds, credit institutions are raising deposit rates. Banks will be able to revalue loans and other investments whose rates are tied to the key rate later if the Bank of Russia decides to tighten monetary policy. A similar situation, when the return on assets will catch up with the cost of funding, is also possible in the future. The probability of this happening will depend on inflationary trends and the hawkishness of future signals from the Bank of Russia.

In addition, the range of factors affecting the profitability of banks has expanded somewhat. The need to increase the volume of liquid assets in order to comply with the short-term liquidity ratio[1] reduces the share of traditionally higher income from loan portfolios. The net interest margin will also be affected by a decrease in the growth potential of retail lending due to the Bank of Russia’s macroprudential measures aimed at reducing the issuance of the most risky (but at the same time the most high-margin) loans. An additional constraining effect will be the reduction in the issuance of mortgage loans due to the curtailment and changes in the terms of preferential programs.

At the same time, higher deposit rates allowed credit institutions to attract a significant amount of funds that had not previously been held in bank accounts, which contributes to the stability and predictability of bank funding and may become a factor of greater freedom in adjusting funding costs.

² In accordance with the Bank of Russia’s procedure for terminating the easing regime on the short-term liquidity ratio (STLR), systemically important credit institutions have to ensure, at their own expense (i.e. without the use of irrevocable credit lines), that their STLRs are maintained at no lower than 40% from March 1, 2024 and no lower than 50% from July 1, 2024.

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