The importance of UK banks’ swap income 

In March 2021, Carraighill published “The Slate”, a new report that assesses the key profit drivers for UK housebuilders and banks. The insights derived from this data help us better understand the key driver of short and medium-term earnings for these sectors. With Brexit now complete and the related uncertainty largely removed, we can assess the outlook for earnings without this overhang. What follows is an excerpt from the report where we estimated UK banks’ swap income.

Introduction

To understand the long-term impact of interest rates on banks, Carraighill has always used a Two Bank Analysis™. This approach segments the key financial statements into:

  1. The customer driven “banking“ business (primarily the spread, costs, and provisions); and
  2. The market-driven “securities” business (either a bond portfolio or a series of interest rate swaps).

This piece focuses on the UK Securities business drivers (around 25-35% of domestic UK banks’ net income).

The key reason why banks hold a securities portfolio is to manage their interest rate risk, which is namely to limit the immediate impact of falling rates on their earnings. This becomes more important as we approach the lower bound in interest rates. In general the cost of bank liabilities are limited to the zero-rate, but their assets (loans and bonds) can continue to fall progressively, squeezing the customer spread. A series of interest rate swaps can taper this effect.

The key determinants of this income are:

  1. Size of the Portfolio: This is primarily influenced by the growth of free balances and low-interest earnings deposits and bank equity less non-interest earning assets. The former generally rises as interest rates decline.
  2. Rates: The difference between the 5-year rolling average level of interest rates or swap rates (generally 3-5 years) and the current rate.
  3. Timing: Individual banks may choose to engage or not engage in hedges depending on the prevailing interest rate level at that time. This brings some level of unpredictability to any analysis. The importance of the hedge has risen as interest rates have fallen.

Estimating UK banks’ swap income

The growth rate of the hedge is determined by rising free balances and low-interest earnings deposits. If these balances are rising, then the banks have the capacity to increase the hedge size.

The Bank of England does not disclose the size of the actual free funds hedge for the banking system. Instead, we used the sum of private sector non-interest earning deposits and sight deposits, weighted as follows:

  • Non-interest earning deposits = 100%
  • Sight deposits = 50%

A 50% weighting is the figure which makes the total system swap book appear proportional to individual bank accounts. It does not imply that banks always use this weighting on their own deposit books. We do not include the impact of equity and non-interest earning assets and broadly assume they cancel each other out.

The second key input to our estimate is the back book 5-year rolling swap rate and the equivalent front book rate. Sovereign bond yields and swap rates have rallied year to date. This is a favourable tailwind for banks as front book pricing has improved on a key component of their balance sheet.

The final step is to multiply these rates by the deposit balances.

Findings

The swap rate evolution remains a major driver of the top line outlook for the UK banks.

Swap Size: The total value of free balances and low-interest earnings deposits grew by close to 20% in 2020. This increased the potential size of the hedge for the UK banking sector moving into 2021. Lloyds has already indicated that it has the capacity to increase its size.

Swap Rate: The 5-year UK rate compressed to 60bps at end 2020 and was 57bps in February 2021. The front book rate ended 2020 at 8bps but has since risen to 48bps. This is a significant improvement and lowers the “normalised see through” free funds income roll for the sector. Of course, this upward move may prove transitory, and earnings of the UK banks will be influenced by the medium-term rate outlook.

Our view on this issue has not been formalised, but we have read extensively on the deleterious effect on longer term economic growth of a high level of gross debt in a country that operates an independent central bank. The overuse of a factor of production (in this instance capital) generally results in lower not higher GDP growth and inflation expectations. Weakening demographics (as we have written about before) also does not help.

Normalised Swap Income: At end 2020, we estimate that the normalised swap income in 5 years’ time is £1.3bn (using front book rates). This suggests a fall of over 80%. When applied to the share of bank earnings from this source, this is significant. The recent sharp rally in swap rates (“rate effect”) has increased the ‘see through’ earnings power to £7.5bn implying a more limited 20% decline. This is a short term positive. Will it persist?

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