Asked about the possibility of a Federal Reserve interest rate hike earlier this summer, BB&T chief executive Kelly King confessed, "I dream about it every night." His remark is typical of chief executives from banks large and small. The most recent batch of banks' earnings reports featured a number of leaders expressing the hope that an interest rate increase would serve as the catalyst they desperately need to improve net interest margins and support revenue streams.
Unfortunately, regardless of whether the Federal Open Market Committee decides to begin raising rates at its September meeting this week, an increase is unlikely to give banks the boost they've been hoping for.
If the Fed follows its recent guidance and raises short-term rates modestly over the course of a few quarters, there won't be much — if any — near-term benefit for banks. Increases of 25 to 50 basis points won't be enough to restore profits even to post-crisis peaks.
Nor will a rate hike return banks' net interest margins back to their highs of five years ago. Federal Reserve data reveals that U.S. banks reported margins of 3.8% in 2010, significantly higher than the 3% margins in August 2015. JPMorgan Chase, for example, reported a 2.1% net interest margin in the most recent quarter of this year.
Nonetheless, the majority of banks have taken steps to make the most of a future rate increase. Many banks have successfully positioned their balance sheets to be asset sensitive. This means that they have more assets than liabilities subject to immediate re-pricing when interest rates rise, which would in turn cause earnings to improve. Also, many banks have gotten some of the fixed-rate loans ("dead weights", relatively speaking) off their books, selling them to the secondary market.
On the liability side of the balance sheet, banks have amassed billions in core deposits over the last several years as clients left the stock market and money market mutual funds in search of better interest rates provided by banks in general. These core deposits — namely checking, savings and money market accounts — are high spread. But they are also highly liquid, which means they could be at risk when rates rise and customers start shopping around at other institutions in search of more attractive returns. I'm hopeful that institutions have well-crafted strategies in place to prevent attrition when rates start to rise. For instance, some banks have already been successful in steering depositors into longer-term, fixed-rate CDs that lock spread in and create "sticky" customer relationships.
All this balance-sheet preparation has allowed banks to stress test their portfolios, using sophisticated financial models to project how rising rates would impact earnings. I would caution, however, that the output from this modeling is only as good as the inputs used in the equation — namely, the assumptions about loan and deposit growth, the timing of loan repricing and, most importantly, the pace and extent to which deposit rates rise.
As we all know, banks traditionally benefit from rising rates. But the degree of benefit depends on whether the wider margins they generate from higher loan rates can outweigh the upward repricing of their deposit counterparts.
This is where there is cause for concern. Over the last five to six years, consumers' pent-up demand for higher rates has intensified greatly. These factors may force the banks to raise deposit rates more quickly than they've modeled in their projections. Here are four reasons why that may be the case:
1.) In the recent period of extremely low deposit rates, a new set of competitors to traditional banks have emerged. So-called online banks have attracted billions of dollars in deposits. Touting the lack of expenses associated with physical branch locations, they have been able to pass these savings along to consumers in the form of higher interest rates. One online institution, Ally Bank, has boasted a 1.29% two-year CD that allows clients to take advantage of rising rates once during the CD's term. Synchrony Bank has advertised a 12-month CD with a 1.25% interest rate. These lenders and their peers are all ready to pounce on traditional banks once rates start to rise, putting pressure on them to raise their rates faster than anticipated.
2.) Consumer purchase patterns have shifted dramatically in the last five years. In the quest for greater value, consumers have warmed up to the new breed of online institutions. With the click of a mouse or a tap on a personal smart device, consumers can conveniently move their money around and are increasingly willing to do so for better rates. It has never been easier to move funds from one institution to another, and consumers have overcome their fear of entrusting savings with banks that lack a physical presence. The result is that consumers are more likely than ever to consider leaving their traditional banks for a new upstart.
3.) Money market mutual funds, badly bruised by the extended period of low rates, are champing at the bit to win back the customers who fled for banks. This will increase pricing pressure at deposit-rich banks.
4.) Consumers are in the driver's seat. They have put up with low deposit rates for some time. This has been particularly difficult for those who rely heavily on monthly interest income for day-to-day living expenses. Consumers' loyalty to their existing bank will be tested if they don't feel their bank is "doing the right thing" by keeping up with the Fed's interest rate hikes. This feeling will be exacerbated when they get their first mortgage statements and find that their monthly payments have increased.
Lest this sound like pure doom and gloom, the overarching good news is that when the Fed does decide to raise rates, it will signal that the economy is gaining momentum. That said, for traditional banks to reap the benefits of higher rates, they will need excellent balance sheet retention strategies — along with a good dose of patience.
Peyton Patterson is the founder of Peyton R. Patterson Consulting LLC. She has previously served as CEO of Bankwell Financial Group and CEO of NewAlliance Bancshares.