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Rising Rates: Lifeline or Mirage?

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Apr 27, 2022

Central banks have raised short-term interest rates with more increases expected throughout 2022 which will boost bank earnings and offer a window to fund needed structural and tactical improvements to better compete with Fintech lenders.

Rising Rates: Lifeline or Mirage?

In mid-March, the Federal Reserve Bank raised its benchmark bank funding rate for the first time since 2018. The widely anticipated move increased the Fed’s benchmark lending rate by 25 basis points to a range of .25% to .50%. Officials at the Federal Reserve also confirmed this is the first of six likely rate hikes in 2022 which should bring the funding rate to 1.9% by year end based on market consensus. The increase affects several aspects of the economy, but its immediate impact will be felt by borrowers with lines of credit, car loans, credit cards, mortgages, and other personal and corporate loans almost immediately seeing rate increases. Rising interest rates are not just a U.S. issue as The Bank of Canada increased rates by .50% to 1% in March, its most significant increase in nearly two decades, while the one-month LIBOR rate has nearly tripled since March 1 from .23% to .62%.

 Bank Earnings Lift

The positive impact on bank earnings will arrive quickly since most banks have primarily shorter-term and floating rate loans on the books which may be promptly repriced bringing substantial revenue increases in coming quarters. Not unexpectedly, several large U.S. banks have already issued updated forecasts for earnings increases. Citizens Bank and Fifth Third indicated full-year net interest income should increase by 10%-14% in 2022, up from previous guidance in the 3%-5% growth range. And Daryl Bible, CFO of Truist Bank, recently told analysts that increases in revenues over the next few quarters will be driven primarily by net interest income given the outlook for higher short-term interest rates.

 As rates increase on loan products, don't look for deposit rates to follow in lockstep. Banks will likely keep deposit rates at current levels for now and only raise them slowly over time despite the swift increases in borrowing rates expected throughout the year. Brian Moynihan, CEO of Bank of America, echoed these sentiments recently "When looking at the consumer deposit base, sometimes I think it's deja vu all over again...In 2015, 2016, 2017, it was about the Fed's going to normalize rates, and you're going to have to raise prices. And we didn't have to." While there are numerous factors in play, increasing the spread between loan and deposit rates will significantly increase bank income. And improving loan demand as global economies shed some of the COVID-driven shackles will also boost loan volume.   Meanwhile holding deposit rates steady – or only raising them slowly - should also help banks bleed off some of the excess deposits residing on balance sheets during the COVID era as customers chase improved yields elsewhere in the market.  

 What About Fintech Lenders?

Rising rates will certainly benefit banks but may or may not help other lenders. Fintechs, which have competed in a near zero-rate environment for several years, will incur an increase in loan funding costs just like other borrowers. Many utilize bank lines of credit which will become more expensive, while equity funding may demand higher returns until the market stabilizes and Fintech lenders prove their performance in the new environment. Banks have a built-in funding advantage as deposits, at minimal cost, can be redeployed at higher rates. When the markets are flush with cash, investors are willing to take more significant risks to generate a better return, but this may no longer be the case. As noted by the Wall Street Journal recently "Disrupting banks when interest rates are near zero is in some ways playing on easy mode. As rates rise, the game will get harder.” But it remains to be seen if banks can take full advantage of their built-in funding advantage by also addressing some of the issues that have driven the growth of Fintechs in recent years.

The cost of doing business for Fintech lenders will increase but what attracts customers to these companies may not change much. Cornerstone Advisors makes the argument Fintechs, despite rate increases, will continue to flourish based on superior technology and customer satisfaction with their interactions which will continue to attract especially a younger demographic. These sentiments were echoed by a PWC report noting although interest rates were the primary consideration when looking for a lender, close behind were the delivery channel and speed of a decision.

 Banks: Stand Pat or Move Forward?

While banks will enjoy a substantial earnings lift in coming quarters, they still must contend with a host of structural issues which will challenge their ability to ensure long-term profitability AND win business from Fintechs. These include earnings leakage in loan and deposit portfolios, friction in customer interactions, less efficient loan approval/funding mechanics and more conservative underwriting.  

 While interest rate-driven profit increases will be substantial in coming quarters, the best bank management teams will utilize this bonanza to drive compelling structural and tactical improvements both on their own and with outside partners such as Profit Insight with the skills and dedication to drive long-term success.

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