Second quarter bank profits fell from a year ago, just about across the board. Most blamed the impact of rising rates, though it was not too long ago that consensus thinking argued that rate hikes would enhance earnings. If that now-discarded view held, banks would have enjoyed a wider gap between what they charged on loans and what they paid depositors as rates rose. So much for glib forecasts! The fact is that things, especially in banking, are much more complex than simple interest rate comparisons. A full analysis must also consider the broader impact of rate hikes, the separate influence of inflation, and the independent effect of recession. The confluence of this array of forces will, to steal an expression popular in the ‘70s, make a mixed bag for bank earnings, large and small, legacy and fintech.
Just a short list of the elements involved can give an idea of the varied effects of just these three major trends, much less particular management decisions. On costs, rates paid on deposits of course matter, but so does the impact of recession on staffing and inflation on wages. Banks also face huge ongoing expenses for technology upgrades. Though chances are good that banks will be able to raise the rates they charge on all sorts of loans, the outlook must also consider the impact — of recession especially — on lending volumes. Prospects for investment banking add yet another nuance, again especially in recession, while raising rates will hit the value of any bond inventory and accordingly hit bank bottom lines. Trading will face crosscurrents from recession and inflation as will credit card fees, and fees on mortgage originations and on custody as well as safe-keeping operations where they exist. What follows takes each of the major macro trends in turn and assesses its impact on these major lines of business.
Recession, though probably the most frightening of the three trends, has the most straightforward effects. Continued slow rates of economic activity will tend to hold back or reduce volumes of all sorts of banking activities. Managements will try to mitigate the impact on the bottom line by cutting back on payrolls, but if history is any guide, staff reductions will fail to provide a complete offset. Meanwhile, a general shortfall in activity will make the ongoing expenses for systems upgrades and technology that much more burdensome, though rising wages and the inability to reduce staff proportionately to the shortfall in activity will induce managements to spend even more on technology and systems than they might have otherwise.
Flows from credit card fees will feel a recessionary pinch, yet another burden on the bottom line. This loss, however, will see an offset as the shortfall in household savings that typically occurs in recessions will increase outstanding credit card balances. Most threatening is the likelihood that recession will bring on more defaults and late payments in credit cards, other personal loans, and business loans, even mortgages. For now, banks report only good experiences in these regards, but the longer economic weakness prevails, the more the risk of credit problems increases. At the very least, banks will need to increase their loan loss reserves, an act that always detracts from the bottom line.
Rate hikes – past and prospective – will also have a more nuanced effect than portrayed by the earlier, easy consensus. True, lenders will surely be able to raise the rate they charge borrowers farther and faster than they raise the rates they pay depositors. That includes lending for mortgages, personal loans, and business loans. But it would be a mistake to assume, as common banking forecasts from earlier this year did, that deposit rates will hold steady. The longer the Fed continues with its rate-raising policy, the more pressure will build to raise deposit rates. Though all banks and bank-like firms will see rates rise, those on the consumer side, with more stable deposit bases, will probably fare better than the more institutionally inclined. As Peter Serene, banking specialist at the consultant Curinos told the American Banker: “You’re seeing rate competition come back to the [deposit] market a little bit sooner than we would have expected.”
Deposit-loan differentials are not all that needs to be said about the impact or rising rates. Mortgage borrowing will likely slow with the rise in mortgage rates, but perhaps less dramatically than business lending. Real estate is, after all, a classic haven from the ill effects inflation has on other classes of assets, especially since it will be a while before the Fed can push mortgage rates anywhere near the ongoing rate of inflation. But if mortgage borrowing holds up, dollar volumes may well drop, as the added expense of supporting a mortgage impels homebuyers to trade down to less expensive properties than they preferred until recently. Those reduced dollar volumes will, of course, count against bank revenues and their bottom lines, both in terms of fees earned and earnings on outstanding mortgages. Certainly, higher mortgage rates will kill the refinancing market that, until recently, provided a rich source of fee income.
Larger banks especially will suffer from the effects on their investment banking activities and other services sold into the financial sector. The flow of new securities issuing will likely slow, due more to the recession than rate increases, but the latter will only reinforce decisions by borrowers to delay. Even more damage will come from the impact of rate hikes as they decrease the value of the bond inventory banks must carry to conduct investment banking activities. It was these kinds of losses on what the banks refer to as the “bridge books” that did most of the earnings damage in the second quarter. As rising rates erode values in financial markets, fees from custody and safe keeping will also wane. It is not that customers will withdraw funds, but this area calculates fees on the value of assets involved and that value will drop because of rising rates and recession.
Inflation, though tied together with recession and rate hikes, will have an independent effect. On the positive side, the ongoing price pressures that this country has suffered and will likely continue to suffer for a while yet will tend to increase the velocity of money as its continual loss of real value impels all to hold it for as short a time as they can. That should increase the demand for an array of banking services, each with its own fee. Inflation will sustain an interest in real estate, too, because it is one of the few assets that can keep up with inflation and, if history is any guide, outpace it. This is why mortgage borrowing will likely hold up despite increases in mortgage rates, but dollar amounts will fall short of the past because the rising cost of supporting a mortgage will impel real estate investors to settle at lower points on the price distribution than previously.
As severe as these prospects are, nothing in this environment points to a re-run of the 2008-09 financial and economic debacle. Banks are better capitalized than they were then and have portfolios with much stronger credit qualities. Households have stronger balance sheets, as do businesses, both small and large. But saying that the nation and the banking industry can avoid that horrible experience is not to say that recession, interest rate hikes, and inflation will not take their toll.