By Nicholas Larsen, International Banker
For much of the world, 2023 will be remembered as an undeniably tough year on the economic front. With inflation far from slain by the end of 2022, most leading central banks continued the fight throughout last year with aggressive interest-rate hikes that severely dimmed global growth prospects, even sending many countries tumbling into recessions. This rising-rate environment, however, allowed the global banking industry to enjoy stellar profits amidst the gloom. But with analysts becoming more confident by the day that rates have peaked and that higher funding costs are more likely to weigh on net interest margins (NIMs), 2024 may not be a bumper year for banks in the same vein as its predecessor.
With net interest margins soaring due to sharp rate hikes, McKinsey & Company described the 18 months to October 2023 as “the best period for global banking overall since at least 2007”, with many lenders enjoying substantially higher net interest income (NIIs) whilst often neglecting to pass on these benefits to depositors in the form of higher interest expenses within what the consulting firm described as a “more benign” credit environment.
But several crucial factors are now alerting financial institutions that a more cautious approach will be required this year, with higher funding costs for lenders, subdued global growth expectations weighing on business and consumer confidence, expanding regulatory requirements for lenders and broadening geopolitical risks being key issues that could prove significant threats to economic stability and banking-sector performance.
Indeed, with authorities coming down harder on banks that fail to make sufficient interest payments to customers, costs for the sector are set to rise significantly this year. Moody’s Investors Service forecasted higher funding costs eating into profitability gains more significantly than during the last two years, along with lower loan growth and loan-loss provisioning needs. “Higher funding costs will shrink net interest margins, while loan production will continue to weaken as rate hikes limit demand and credit standards tighten,” the rating agency noted in its “Banks–Global 2024 Outlook: Negative as tight financial conditions and economic slowdown sting” report published on December 4. “Provisioning expenses will follow increases in asset risks, while operating expenses contend with rising tech-related investments and new regulatory costs.”
The economic outlook also remains decidedly precarious at present. While it does seem that the worst of inflation has been and gone, it is still far from being extinguished in many parts of the world. As such, the persistence of higher-for-longer monetary regimes will dim the global macroeconomic picture throughout much of 2024 before a presumed downward readjustment of rates later in the year ushers in a return to normalisation, with inflation contained around formal central bank targets and GDP (gross domestic product) growing steadily.
When such stability will be achieved, however, remains up for debate as strong labour-market conditions and sticky demand continue to pressure policymakers into maintaining their higher-for-longer policies for the time being. Businesses and households thus look set to face elevated borrowing costs throughout the year that will, in turn, weigh on banks’ bad-loan provisions, while higher rates may also trigger hard landings for several leading economies, with the resulting recessions and rising joblessness further lowering loan-repayment capacity, liquidity and asset quality.
“Previous rate hikes will lead to greater asset risk and reserve buildups,” Moody’s added in its December 4 assessment, whilst also stressing the significance of the expected slowdown in China’s economic growth due to lower spending by consumers and businesses, weaker exports and lingering troubles within its real-estate sector. “Rising unemployment in advanced economies will weaken loan performance. Commercial real estate (CRE) exposure in the US and Europe is a growing risk; in Asia-Pacific, specific property markets face stress. Chinese banks face risks from slower economic growth and second-order impact[s] from a prolonged property downturn.”
This view has been echoed by S&P Global Ratings, which recently stated that the weak economic outlook presents particularly strong headwinds for banks’ business volumes, asset quality and financing conditions. That said, the rating firm did acknowledge in its November 16 “Global Banks Outlook 2024: Forewarned Is Forearmed” that most banks’ earnings will continue to benefit from high interest rates. “Monetary policy normalization is taking place gradually, and speed depends on central banks’ actions against inflation. Banks are well placed to weather this transition, but strong funding franchises are becoming a competitive advantage again.”
On the technology front, a rapidly evolving banking environment will continue to boost efficiency across the sector this year, with customers expected to increasingly enjoy more innovation-driven banking experiences. Specifically, many are touting generative AI (artificial intelligence) as a game-changer for the industry. McKinsey projected the technology to raise sector productivity by 3 to 5 percent and reduce operating expenditures by $200 billion to $300 billion.
Prakash Pattni, IBM’s global managing director for financial services digital transformation, stated he expects generative AI to continue dominating the financial-technology (fintech) space this year. “We see an influx of fintech start-ups offering generative AI solutions, and venture capitalists are increasingly interested in investing in them,” Pattni explained in a December 12 article for International Banker, adding that there remains a clear lack of understanding about how to implement such solutions and overcome the many challenges AI represents. “In response, we will see fintechs and banks work closely together to develop innovative, customer-centric products and services, such as AI-powered investments and fraud-detection systems they can bring to market.”
Despite the technology’s development still being in its infancy, banks are expected to push ahead with forming clear AI strategies and governance frameworks as well as testing and deploying generative-AI solutions for customers. “The most visible application of generative AI will be chatbots, with customers increasingly communicating with banking apps and online money services in natural language,” according to strategic advisor and author Bernard Marr, writing in Forbes on December 11. “Expect to see innovations such as personalised financial planning and bespoke investment strategies based on customer profiles and behavioural data, all thanks to generative models like those powering ChatGPT.”
On the regulatory side, banks will face increasingly burdensome supervision. Fitch Ratings stated it expects additional rules to be levied to protect lenders against the impacts of high interest rates on rate-risk-sensitive assets, debt-service burdens and financial stability. The rating agency predicted that jurisdictions enacting the final Basel III rules would further reduce their appetites for riskier assets, while regulatory authorities would focus on governance, climate, financial crime and cyber risks.
“Macro concerns and the full and timely implementation of final Basel III rules remain primary focuses, though there is potential for looser macroprudential policy as risks linked to households and corporates start to crystallise,” Monsur Hussain, Fitch’s head of financial institutions research and lead author of the “Fitch Ratings 2024 Outlook: Global Banking Regulation” report, noted upon its publication on November 28. “Tighter supervision across risk-management disciplines, including cyber and anti-money laundering risks are likely.”
Those risks are not the only ones set to inflict serious downside potential on the global banking industry this year. With elevated geopolitical uncertainties, particularly related to the brutal ongoing wars in Ukraine and Gaza, banks could be exposed to potential erosions of credit fundamentals, with emerging-market lenders most notably in the firing line. According to S&P, such concerns “could slow reform implementation and reduce long-term growth”. Coupled with persistent climate risks, moreover, geopolitical unrest may also send inflation higher again, as the potential closures of key maritime oil-delivery routes and disruptions in agricultural supplies due to pronounced weather-pattern changes trigger potential spikes in commodity prices during the coming months. If so, one can reasonably assume that central banks’ higher-for-longer policies will remain in place throughout much of 2024.
Nonetheless, banks are expected to continue to make sound progress regarding their green-finance offerings, with lenders recently observed being active in the sustainable-bond market. According to ING, for instance, credit institutions across the globe issued more than €70 billion in EUR sustainable bonds in 2023 to the end of October, over €10 billion more than the sustainable supply during the same 10-month period in 2022. “We expect green, social and sustainability issuance of banks to reach €80 billion this year, up €8 billion versus 2022,” the Dutch bank explained. “While banks will still issue notable amounts of sustainable debt in 2024, slower lending growth will probably make it difficult for them to continue to issue at the same pace as this year. We expect to see slightly less sustainable supply next year, despite our forecasted modest rise in total bank supply.”