The old saying by Benjamin Franklin goes, “Nothing is certain except death and taxes.” However, in today’s banking market there seems to be another certainty: rising interest rates.
The Federal Reserve has been signaling its intention to raise interest rates for a few months. Previously, the Fed was quiet about its position and leanings; however, this administration has firmly expressed its plans. Last week, the Fed announced it would raise interest rates by 0.25%, with more to come, triggering some choppiness in the equities market. Two of the most significant areas that will be affected by the rise of interest rates are the U.S. economy and the household economy.
The U.S. economy
Growth and personal wealth: An increase in interest rates may trigger a decrease in economic growth. This is because higher interest rates raise the cost of borrowing money, reducing disposable income, and limiting consumer spending.
Inflation: Theoretically, inflation should be reduced by rising interest rates, as high rates discourage borrowing and encourage saving, which tends to slow down the economy. However, there are numerous other factors that influence inflation, for example, the currency markets. The currency markets are a huge unknown as the balance of payments, i.e., the ratio of imports-exports, can change due to a stronger dollar, caused by the higher interest rates. A stronger dollar makes U.S. goods and services less attractive in the global economy and could affect demand.
Unemployment: There is a correlation between inflation and unemployment that suggests that lower inflation resulting from higher interest rates may yield higher unemployment levels. Excluding the statistical outlier to unemployment that was created by the pandemic, which now seems to be rebounding to more normal figures, it is anticipated that unemployment may increase with the rise in interest rates. In practical terms, as the price of inputs and goods increase, corporations will be forced to choose between higher input costs or higher employment costs. As employment costs may be more fixed in comparison to input costs, it is reasonable to anticipate that employment will be cut resulting in more employees out of work.
Credit: Higher borrowing rates could tighten business and personal credit as more borrowers are at a larger risk of default with increased interest rates. Furthermore, bonds are just another form of corporate debt. Higher rates lead to lower bond prices which means borrowers either get a lesser yield compared to the market or must sell the bond at a discount to keep up with better, higher interest rate investments.
These factors could lead to an overall weaker economy which could result in a bear market or, at least, turbulent short-term sessions.
Household liquidity and debt: Higher rates should encourage saving by consumers and households, and this is needed as according to Bankrate, 51% of Americans have less than 3 months of expenses on hand for emergencies. However, the average American also has around $41,000 in debt – either credit card, personal loans or vehicle debt, excluding student loans or mortgage debt. Most types of debt are not typically fixed rates, meaning that the increase in interest rates will hit consumer pocketbooks directly in the form of higher monthly payments.
Home prices: Rising interest rates will also affect home values. Home values decrease as interest rates go up because sellers must tailor the asking price to what buyers can afford. However, this phenomenon could aid in normalizing home price appreciation.
So, what does this mean for your financial institutions?
Typically, financial institutions benefit from higher interest rates by increasing the spread they receive between loan rates and deposit rates. Furthermore, financial institutions have been looking to increase their number of loans, as the pandemic triggered a wave of stimulus check deposits. A dip in household liquidity might offer financial institutions the opportunity to provide digital lending, by leveraging the modern technologies of fintechs.
However, financial institutions face risks to their credit portfolio with higher interest rates as marginal credits may not be able to survive the interest rate shock to their already marginal financial performance model. For example, “Watch” credits will now get downgraded to “Special Mention” or “Substandard” and accordingly, Allowance for Loan and Lease Losses (ALLL) is impacted effecting net earnings. In addition to this pressure, fixed rate loans on the books are not able to reprice and the financial institution will face margin compression on that segment of loans.
In the case of rising interest rates, financial institutions should be actively reviewing their loan portfolios, looking for loans that are either underpriced or now further out on the risk curve. Based on this assessment, financial institutions may choose to encourage those relationships to other financial institutions or outright exit them. This can be done on platforms for loan trading, selling and participation offered by technology vendors, which allow financial institutions to exchange opportunities. Today’s unique environment particularly calls for financial institutions to take advance of these modern and open solutions that assist with the strategic distribution of loans, finding new liquidity, or divesting away from a particular asset concentration.
It remains to be determined if the fallout from the actions of the Fed was a better choice in the long run than the impact of continued, unchecked, increase in prices on almost everything across the board. What is certain is that the reaction and correction of the market to the rise in interest rates is inevitable. The impact on the U.S. economy and the household economy will likely be significant, while odds are that most financial institutions will come out as winners, especially if they leverage loan trading platforms to diversify their portfolios.