To be sure, bank net interest margins continued to increase from 1.6 per cent in 2000 to 1.8 per cent, 1.9 per cent, 2.1 per cent, 2.5 per cent, 3.1 per cent and an estimated 3.3 per cent in 2001-06 respectively.

Bank profitability has been strong, with interest income rising at a faster clip than interest expense. Increased profitability has been made possible through a combination of rising net interest income and non-interest income. The latter has, since the financial upheaval, constituted an increasing  proportion of the banks' total income. Despite the fact that banks have made tremendous strides in shifting their revenue mix to reflect a much larger proportion of fee income, variations in net interest income still remain a key determinant of bank profitability. And with improved asset quality and declining non-performing loans, Thai banks have been able to set aside a much lower provisioning level than the periods immediately following the economic meltdown.

Thailand's recent experience seems to belie the conventional wisdom that bank net interest margins tend to decline following the convergence of short-term and long-term interest rates. The conventional view among financial market observers holds that banks pay interest on their liabilities based on short-term interest rates while making loans tied to longer-term interest rates. Accordingly, a rising interest rate environment and a flattening yield curve mean that bank net interest margins will be compressed as a result of the cost of deposits and borrowing increasing faster than the yield on loans. Banks with a liability-sensitive balance sheet - an asset/liability profile characterised by liabilities that re-price faster than assets - are, thus, more vulnerable to a rising rate environment.

Paradoxically, there does not appear to be any positive correlation between changes in the yield curve spread and bank net interest margins. In fact, over the 26 months that the central bank has raised its benchmark rate, the nominal yield on the two-year government bond has jumped by 256 basis points with the yield on the 10-year bond rising by a mere four basis points. This phenomenon, evidenced by non-parallel movement in the yield curve, has resulted in a dramatic flattening of the yield curve.

Rising interest rates and a flat yield curve have so far failed to stymie Thai banks. Surprisingly, they have been able to move past the flat yield curve in recent years without sustaining any damage to their bottom lines. Why then are bank earnings not sensitive to changes in the shape of the yield curve? Perhaps, the deep-rooted theory that bank net interest margins are influenced by the slope of the yield curve is not applicable worldwide, particularly in countries where a deep, liquid and mature bond market does not exist.

Upachai Sophastienphong

Special to The Nation

Upachai Sophastienphong is chief economist for Siam City Bank.