Higher interest rates signal end of one-stop shop banks
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In early February, the St Louis branch of the Federal Reserve published a blog post warning that higher interest rates could “complicate” banks’ finances.
The post was as prescient as it was optimistic. The Fed’s supervisors said rising interest rates created both “challenges and opportunities for banks”. They suggested that banks should carefully analyse the situation, but also said there were several steps banks could take to mitigate any issues.
Less than a month later, Silicon Valley Bank (SVB) failed, largely due to the effect of sharply higher interest rates, kicking off the worst period of banking turmoil since the Great Financial Crisis. Signature Bank quickly followed into the abyss. Shares of dozens of banks plunged in value, raising questions about their survival, too. In Europe, UBS bought the long-suffering Credit Suisse in a government-backed deal that saved its rival from collapse.
Emergency measures from the Federal Reserve, billions of dollars from the federal deposit insurance fund, and tens of billions of loans from the government-backed Federal Home Loan Banks quelled the crisis. Few, if any, banks now seem at risk of failing. However, while the crisis has passed, the challenge from higher interest rates, as the St Louis Fed warned in May, has not.
Higher interest rates have ushered in a new normal in the banking industry. A slowing economy and higher scrutiny from regulators following recent bank failures have largely capped the amount of lending that banks are able to do at elevated rates.
And banks are seeing the effects of higher rates on borrowers, particularly those in commercial real estate. Defaults on corporate loans, which generally carry interest rates that float — meaning they automatically adjust with market rates, not just when the borrower refinances — are also on the rise.
The European Central Bank warned in May that European lenders, such as SVB and other US banks that ran into trouble, would see the value of their assets fall faster, on average, than the value of their debts — a particularly bad scenario for a bank if interest rates continued to rise. For the average bank, the central bank concluded, the drop in book value would be a very manageable 4 per cent. But the ECB also found that, for a quarter of European banks, the hit from rising interest rates would be high enough to force those banks to take steps to mitigate the damage.
Already, a number of institutions, including Citigroup and Goldman Sachs, appear to be abandoning the notion that the best model for a global bank is to offer all services to everyone — the supermarket model of banking — something that seemed to be banking gospel just a decade ago.
“You have to look at each business from the ground up and not bottom down at this point,” says Greg Hertrich, who is the head of deposit strategy at Nomura. “Twenty-five years ago, everyone wanted to be a one-stop shop, and that has changed.”
The biggest effect of rising rates, at least so far, has been on the banks’ bottom lines. For much of the past decade, banks have been one of the biggest beneficiaries of low interest rates, and essentially — at least for them — free money.
With interest rates near zero, depositors had nowhere else to go with money that they did not want to risk in the market. As a result, customers had to accept — and eventually got used to — receiving no interest on their accounts. The rise of internet banking, along with ATM and other account fees, made bringing in customers and their deposits all the more lucrative for banks.
That started to change in early 2022, when the US Federal Reserve began raising interest rates to slow quickly rising inflation. In the first quarter of last year, the average US bank had an annual-equivalent funding rate — that is how much in interest it paid compared with its total assets — of 0.15 per cent. That funding rate has jumped nearly 12 times to just under 2 per cent in the past 18 months, mostly driven by the rising costs of deposits, with some banks offering interest rates on accounts in the 5 per cent range. Lending income is rising as well, but not nearly that fast.
In the second quarter of 2023, the average bank saw its interest income rise just 8 per cent from the quarter before. Interest expense, however, jumped 27 per cent.
“It is the fact that funding costs have gone up and your assets, your loans and bond investments are worth less,” says Hertrich. “My guess is that they are going to pull every lever that they can.”
Some banks are already starting to retreat from, or even exit, consumer banking.
Bank of America chief executive Brian Moynihan had long talked about the importance of bank branches. But even BoA is cutting branches at a time when the cost of bringing in new deposits, and holding on to the ones you have, is much greater than it has been for some time. Last year, the number of BofA branches fell to 3,900, down 7 per cent from the year before. It was the first time the bank had fewer than 4,000 branches since shortly after its merger with NationsBank in the late 1990s.
Just a year ago, Goldman Sachs was investing heavily in consumer banking in the UK, in an effort to win customers for its fledgling online bank Marcus. These days, it appears to have lost its interest in Marcus and consumer banking in general, both in the UK and at home in the US. Late last year, Goldman stopped making consumer loans through Marcus and scrapped plans for a checking account. It did recently launch a high interest savings account, initially paying close to 4.5 per cent a year, but in a partnership with Apple and under the iPhone maker’s brand, not Marcus.
Emmanuel Dooseman, global head of banking at accounting and consulting firm Mazars, says there are only so many options for banks. Many lenders, he points out, committed to long-term loans when interest rates were still low, which will weigh heavily on profits.
There could, he says, be a renewed interest in small business lending, as well as mortgage lending, where rates have risen. But that will expose banks to the risk that high-interest loans made now will go unpaid if the economy sours.
“There is no short-term answer,” notes Dooseman. The only way for banks to deal with lower lending income is to cut costs until profitability rebounds. Last week, Truist, one of the US’s largest banks, announced a fresh round of cuts that it says will save $750mn dollars in expenses per year.
“There are no quick fixes,” says Dooseman. “It’s just time.”