Will the long awaited hike in interest rates turn out to be good or bad for U.S. banks? The honest answer is probably yes to both possibilities, depending on the size of the bank in question and how the Federal Reserve manages monetary policy over the next couple of years.
In case you just got back from Mars, the Fed announced on December 16 that it was raising the interest rate on overnight borrowings between banks (known as the federal funds rate) by a quarter of a percentage point. The significance of the Fed’s action had less to do with the size of the increase than with the fact that this was the first time the central bank had raised rates in more than seven years. There was a lot of commentary after the rate hike about how this would impact the U.S. economy, although a strong case can be made that this was actually a vote of confidence in the economy’s long-term prospects. The job market has rebounded since the recession ended in June 2009 and unemployment was 5.5 percent in May, according to the Bureau of Labor Statistics. While the recovery is still a work in progress, Fed Chairman Janet Yellen expressed confidence in the economy’s future during a press conference after the rate increase was announced.
Although the Fed’s central mission is to fight inflation, deflation—which is a persistent decline in asset values and consumer prices—has actually been a much greater risk in recent years. Having cut the fed funds rate to nearly zero, and embarking upon a controversial strategy of massive bond purchases to pump money into the economy—known as quantitative easing—there was little more the Fed could do other than wait for the economy to heal itself, which it largely has. Yellen and the Federal Open Market Committee, the 12-member group at the Fed that actually sets monetary policy, has been waiting for an opportunity to begin pushing rates back up. Clearly the time was right.
How will this affect the nation’s banks? The impact of a quarter-point increase in the fed funds rate should be manageable, at least for now. Comptroller of the Currency Thomas Curry has expressed publicly his concern that some banks might be exposed to interest rate risk as the Fed tightens its monetary policy. Large banks, which tend to use variable rate pricing on their commercial and industrial loans, permitting lenders to reprice them if rates go up, will probably experience less economic impact than smaller banks. Many small banks don’t have the same flexibility to reprice their business loans. So as rates go up, smaller banks could actually see their net interest margins tighten even more as their deposit costs rise.
Still, the rate increase had been anticipated, predicted and over analyzed for so long that no bank should have been taken by surprise. Managing interest rate risk is an important task for management and the board, and the industry has been given ample time to prepare.
Ultimately, the impact of higher rates on the banking industry might be determined by how quickly the Fed tightens its policy. The Fed has said that it wants to continue raising rates gradually over the next few years—the exact term it used was to “normalize” rates but how gradually? Hike rates too quickly and some smaller banks could be stressed if they can’t reprice their loan portfolios fast enough to keep pace. But if banks are impacted disproportionately depending on whether they are asset or liability sensitive (being asset sensitive means your loans reprice faster than your deposits, while being liability sensitive means the reverse is true), one thing that would hurt everyone is a slow-down in the economy. Here, I would expect the Fed to be very careful. Having nursed the economy back to health, I think the last thing it wants to do is tip the economy back into a recession by acting too aggressively.
At the very least, banks should know what to expect, and the Fed—which has been very transparent under Yellen—will no doubt let them know when to expect it.