With the federal government's upward bias clearly established – and guidance for more on the way – financial institutions now find themselves undoubtedly in a rising interest rate environment. We’re often asked by clients and others in the banking industry what this means for marketing strategy. Below is a summary of our analysis and some quick thoughts about how banks can think about gaining advantages from the situation.
If you listen to casual pundits, rising interest rates are good for banks. They say rising interest rates bring easy profits. This idea sounds seductive; however, history proves it wrong. Data shows most banks aren’t big winners when interest rates rise. And worse, many in fact lose.
The last time the US economy saw an orchestrated set of rate increases was from June 2004 to June 2006. In that time, the Federal Reserve Open Market Committee raised rates 10 times, from 1.25 percent to a peak of 5.25 percent. During that period, more than half of banks saw their profit margins erode. Why? Simple – Their cost of funds increased faster than their yield on earning assets. What banks do now will determine their performance over the next few years.
Before continuing, it’s worth mentioning this phenomenon doesn’t impact all institutions equally. Community banks, among our current clients, face a greater threat from the changing environment than banks as a whole because they are particularly liability sensitive.
On August 30, 2016, Federal Deposit Insurance Corporation Chairman Martin Gruenberg explained the challenge: “Community banks continued to hold a larger share of longer-term assets on their balance sheets than the overall industry. This has helped community banks sustain their net interest margins in a low rate environment, but it has left them more vulnerable to higher short-term interest rates.”
In other words, the nation’s community banks, on average, have more work to do than any other segment of the industry.
Those who understand banking know that the industry's cost of funds and yield on earning assets engage in a very close dance. Movement in one is followed closely by a move in the other. The trick is to determine, and hopefully influence, which partner gets to lead.
With interest rates near zero since late 2008, most interest-bearing investments are also hitting near zero yields. As a result, the distinction between non-interest-bearing deposits and interest-bearing products such as Certificate of Deposits (CDs) lost much of their distinction. Further, the difference in yield between traditional interest-bearing bank deposit products, such as CDs, and alternatives, such as government bonds, have hardly merited the effort. As a result, the banking industry has enjoyed a windfall surplus of low- to no-cost deposits.
These deposits have driven strategy for banks for almost a decade. Consultants to the industry, however, estimate that non-maturity bank deposits climbed to as much as 25 percent above normal historical levels during this period. These deposits are now at risk.
While it’s hard to forecast how much of these excess deposits will leave one bank or another, or leave banks altogether for other higher yielding securities, it’s clear that the table is now set for such departures to occur. How a bank reacts to this challenge will determine financial performance in the rising interest rate environment.
So what might a bank consider given this set of conditions? While it’s not easy to change quickly, banks should begin by accomplishing these three steps:
In the end, these steps will help lower the cost of funds and allow a bank to avoid being forced to raise rates on deposits to compete for funds.
Deposits are just one-half of the dance. While you want deposits to lead by keeping their volume high and cost low, there’s certainly much that can be done to make sure loans are graceful partners.
Obviously, variable rate loans in a rising rate environment are good for a bank. Banks with a higher proportion of such loans are more likely to see increased interest income in advance of cost of funds increases. As a result, shifting emphasis toward sectors that are more open to, or prefer, variable rate loans is one strategy worth considering.
One proven method for enhancing a variable rate portfolio is to seek out more Commercial & Industrial and Construction & Development lending. Not all markets are conducive to such customers, however, some, such as the greater Washington, D.C. area, are particularly rewarding.
Banks positioned to win in a rising interest rate environment share these characteristics: a relatively high balance of cash or cash equivalents, a low current cost of funds, relatively low loan-to-deposit ratios and a high percentage of earning assets that float with interest rates. Those banks that lagged in the prior environment may be better positioned to take advantage of this shift. For those who were well positioned in the previous environment, changing may not be easy; however, this should not dissuade banks from taking steps to realign. Aligning marketing efforts with these goals can pay dividends and should be explored in the near term.
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