Do Singapore’s Banks Have to Fear an Interest Rate Hike in the US?

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The share prices of Singapore’s three major banks, namely, DBS Group Holdings Ltd (SGX: D05)Oversea-Chinese Banking Corp Limited (SGX: O39), and United Overseas Bank Ltd (SGX: U11), have been under pressure in 2015, declining by more than 10% since the start of the year.

One of the key things gripping investors’ attention at the moment is the possibility of an interest hike in the future by the the Federal Reserve in the U.S. Should investors in the three banks be worried about a rate hike?

A story of interest rates

First, we need to determine if interest rates in Singapore will rise when a foreign country 15,000km away (the U.S.) decides to raise its interest rate?

Interestingly, the answer is yes. According to a study done by the Monetary Authority of Singapore, one of the most important interest rates here – the interbank interest rate – is affected by the “US interest rate adjusted for expected change in the Singapore-US Dollar exchange rate.

In other words, if and when the Federal Reserve does increase rates, Singapore would most likely experience the hike as well.

What really matters

The second question to ask now is this: Does the rate hike really matter for the banks? There are two angles to the answer: Yes and No.

Let’s explore the ‘Yes’ side of the issue first.

A bank is basically both a borrower and a lender. A bank borrows money from depositors like you and me, or from other banks. Then, the bank will turn around and lend that money out at a higher interest rate, thus earning its keep from the difference between the interest it has to pay out and the interest it gets to collect (in finance parlance, this is known as the spread).

So, when there is an increase in interest rates, a bank’s cost of funds (such as the rates customers demand to deposit their money in the bank), would increase too. If a bank is unable to push through higher lending rates, it might have to bear an increase in cost, thereby hurting its profit margin.

It’s also tricky for a bank to increase the interest rates for the capital that it lends out. That’s because higher rates may increase the pressure on borrowers, leading to higher default rates if borrowers can’t withstand pricier loans.

Let’s dig into the “No” part of the answer now.

The main reason, in my opinion, why the Federal Reserve would raise rates is that it sees the US economy growing strongly. And if the US economy is expanding, a rate hike may be a sign of future growth in the global economy, and by extension, Singapore.

With more economic activities come more business for Singapore’s banks. Given the possibility of higher demand for loans, the net interest margin of the banks (the interest rate spread I mentioned earlier) may even expand in the future, resulting in higher profits for them.

Foolish Summary

At the end of the day, the quality of the loans that a bank has made is the key to its future profitability. If a bank has been prudent and conservative when issuing loans, it stands a much better chance of navigating different types of market conditions successfully.

For example, OCBC came out of the Great Financial Crisis of 2008-09 with the lowest non-performing loans ratio and lowest credit losses among the Singapore banks. Its non-performing loan ratio actually declined to just 0.9% in 2010. A strong loan portfolio gives a bank a solid balance sheet and with the latter, OCBC was able to steer itself successfully through the crisis, even growing its net profit in each year from 2008 to 2012.

If, on the other hand a bank had been aggressive with issuing loans over the past few years, stuffing its portfolio with less-than-ideal loans,  it might be caught without a strong balance sheet during moments when that is needed the most.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore writer Stanley Lim doesn't own shares in any companies mentioned.