In March, the Federal Reserve raised the target federal funds rate by a quarter of a percentage point, marking the second rate increase in three months. The Fed has indicated that it expects to make additional rate hikes in 2017. The Fed’s adjustment of interest rates is largely a reaction to current economic conditions, so it can be difficult to accurately speculate about the future. However, there are some indicators that can help predict how a rate hike will influence a bank’s customers and, ultimately, its bottom line.
Determining how interest rates will impact banks’ customers hinges largely on the age range they fall into, for retail banking. Other customer segments also can be expected to experience differing impacts to rising rates.
Banks can uncover opportunities for portfolio growth and more effectively manage risk by assessing how a rate hike impacts various consumer demographics and drilling down to examine key regional economic indicators, including local unemployment statistics, average personal disposable income, real estate prices, and more. Leveraging such resources allows fine-tuning of the sensitivity of banks’ loan portfolios to interest-rate fluctuations.
Segmenting your customer perspectives
Let’s examine some of the difference banks will likely see.
For young adults and recent graduates, their financial energy is focused more on consuming and borrowing, rather than long-term investing. Rising interest rates mean that typical activities, like refinancing or taking out a new student loan will become more costly. Auto loans and consumer debt will become more costly at a faster rate as well.
As for mortgages, young adults looking to purchase a home will consider locking in a rate before additional expected rate hikes, rather than opting for an adjustable rate mortgage.
Compared to younger consumers, middle-aged individuals tend to have more assets and debt that could be affected by an interest rate increase. Homeowners who have an adjustable-rate mortgage will likely consider refinancing to a fixed-rate mortgage.
Additionally, older consumers typically have a greater proportion of dividend-paying investments than younger consumers, and these investments can be negatively affected by an interest rate hike.
Considering small business outlook
Small business owners, a particularly valuable customer segment for banks, will also quickly feel the impact of the rate hikes.
Following the financial crisis of 2008, interest rates hovered at historically low levels. During this time, many banks refrained from lending freely due to the tighter net interest margins driven by the small difference in cost of funds versus market-driven interest rates, making it difficult for banks to profit from loans. Additionally, the economic impact from the 2008 crisis created an imbalance in the risk/return consideration for many small business loans.
So, over the past decade, banks have avoided taking on riskier credit opportunities associated with small business loans.
One of the results of the banking industry’s restricted appetite for loans was the advent of alternative lenders. These credit newcomers recognized the gap in the market, as small businesses that needed capital were being turned away by traditional financial institutions. To address this, alternative lenders offered capital much more freely—by charging extremely high interest rates.
However, with the Fed’s rate hikes, banks will see opportunities for a more profitable loan portfolio and consequently, will be inclined to increase their lending initiatives. Banks will lend more freely, and although interest rates have increased, the rates offered by banks for small business loans are typically better than the rates offered by alternative lenders.
Given current economic conditions, the Fed anticipates additional rate hikes this year and for small business owners, this means the cost of capital will continue to increase. Still, rate hikes signal a healthy economy and although small businesses will pay more for financing, confidence in the economy encourages spending and further economic growth, potentially benefitting small business owners.
Entrepreneurs looking to launch a business or existing companies looking to expand will likely try to obtain capital before another rate hike and will lock in the current interest rate if they can.
In this rising rate environment, waiting to act will cost money.
Watching for a short-lived, wide window
For banks, there will be a short window of time that the net interest margin will be highly profitable, during which the interest rate received has increased but the cost of funds, especially on certain deposit products, remains low or is slower to adjust.
As a result, banks can use this time to leverage a favorable net interest margin. Small businesses will be incented to take advantage of expanded access to capital before additional rate hikes, so banks will likely see an increase in small business loan applications.
Preparing for competitive drive
Banks that have streamlined the application and underwriting processes will be better positioned to benefit from increased demand driven by the ripple effects of additional rate hikes.
One strategy, offering a customized loan application online, ensures that lending opportunities are not restricted to a bank’s branch hours and the enhanced accessibility of an online application enables a bank to expand its reach and touch a wider customer base, regardless of location.
This also allows banks to customize the amount of information that applications must supply. This can support faster turnaround times, as the bank can determine the level of financial statement analysis and profile information required, framed to match its risk appetite.
With a growing loan portfolio, banks should shift how they manage risk in their loan portfolios. Portfolio risk management must be about weighing all costs—including balancing costs incurred from delays in recognizing credit risk as well as the costs associated with missed opportunities.
A bank’s best prospects are its existing customers, so banks that understand how to derive insights from data can enhance their cross selling efforts. For example, identifying a small business’ recent growth and low credit risk may signify its potential appetite for a new loan, enabling the bank to present a targeted offer to the customer.
Lending competition will stiffen, as an emphasis on portfolio growth will be common. Banks must strengthen their ability to swiftly identify both positive and negative trends. By using data analytics and leveraging insight garnered from portfolio risk management activities, banks can assess how rising interest rates will impact their customers, both consumer and small business, and ultimately, the loan portfolio.
About the authors
Mike Horrocks is senior director, solutions management, at Baker Hill. John Robertson is senior business process architect at Baker Hill.