How Will Fed Tightening Impact Community Banks?

by: Dr. Bill Conerly

The Fed is likely to start raising short-term interest rates in 2015, leading community bankers to wonder, "How much will this help me?" There is no generic answer, but it's clear that the typical community bank will reap a substantial one-time benefit.

The assumption behind this study is a one percentage point increase in the Fed Funds rate, which would impact virtually all short-term market rates by an equal amount. In my forecast, however, the rate hikes begin in May 2015, then move up gradually, ending 2015 one percentage point higher. Because of the ramping up of rates, it's inaccurate to apply the one-point rate hike to a full year's balance sheet. However, that method gives us a good ballpark estimate that can be adjusted upward or downward to fit an actual year of bank data.

Interest Rate Forecast 2014 07

The usual approach to looking at interest rate impacts begins with a static balance sheet. This makes sense as a starting point, though too many analysts also use it as a finishing point. After this step, then, we'll look at how Fed tightening will impact the balance sheet.

To put some meat on the bones of the analysis, I'm looking at a typical bank with one billion dollars of assets. (I pulled data on the 142 banks that have assets within ten percent of that benchmark, averaged the data, then normalized to exactly one billion dollars in assets.)

A billion-dollar bank has, on average, $928 million of interest-earning assets, but only $734 million of interest-bearing liabilities. An extra percentage point of interest, then, would be worth one percent of the difference between $928 million and $734 million, or nearly two million dollars per year. However, some assets won't reprice in a year's time. Excluding them, the benefit is less. However, most banks have match-funded longer maturity loans, based on my conversations with bankers. As a result, a similar amount of interest-bearing liabilities will also not reprice. Because more assets will earn high interest rates than liabilities will pay higher interest rates, a Fed Funds increase of one percentage point would add about 20 basis points to pre-tax return on assets. But wait! There's more!

Interest rates on deposits are unlikely to rise point-for-point with the Fed Funds rate. In more normal times, we would expect six-month CDs and money market accounts to move pretty much in line with Fed Funds, but we have not been living through normal times. Compare 2007 with 2013. Back then, the average interest cost of all deposits was 3.9 percent, compared to a Fed Funds rate of five percent. A bank could afford to open new deposit accounts, and even to mail out monthly statements to free checking customers. Now, however, with the Fed Funds rate at 11 basis points, it's not easy to pay interest that is 1.1 points lower. (The rise of fees on deposit accounts is one attempt at doing this.) As interest rates rise, banks will regain the normal spread between market interest rates and deposit rates. In fact, a full percentage point rise in the Fed Funds rate really does not have to be accompanied by any increase in deposit rates.

In practice, banks will probably throw a bone to their deposit customers as rates rise, adding perhaps ten basis points to deposit rates to the first hundred basis points of Fed Funds gain. After that, deposit rates will rise almost in pace with Fed Funds. One implication of this is that the first percentage point of rate hikes will be far more valuable to banks than the second.

Under this assumption of slow increases in deposit rates, the first percentage point of interest rate hike by the Federal Reserve bumps the pre-tax ROA by 60 to 70 basis points. Taxes are too hard for an economist to figure, given past loss carryovers.

All of this so far has assumed a static balance sheet. Now let's take the step that plenty of ALCO analyses ignore: how the balance sheet will change.

When the Fed tightens, it slows the growth of the money supply, most of which is bank core deposits. This has belied some past analyses that determined rising rates were good for banks. When deposit growth slows, that is negative and can sometimes be a larger impact than rising rates.

In the present situation, though, most community banks are flush with deposits. Slower growth of deposits is fine, at least for a while.

Loan volume is a different story. It's misleading to think that interest rates will choke off loan demand. Instead, higher loan demand comes with a stronger economy, and is thus part of the Fed's decision to increase interest rates.

In fact, commercial loan growth has been accelerating lately, in pace with talk about the Fed's tightening. Commercial and industrial loan volume had increased by 7.2 percent in the 12 months through January of this year. In the past four months, though, the annualized growth rate has surged to 17 percent. The interest earnings on loans is so much greater than the interest earnings on deposits at the Fed or securities that loan growth is the best part of the news.

The all-in impact of the Fed tightening, then, is very positive. I'm not ready to quantify the benefit from loan growth that would precede the Fed's move, but it should be substantial. Bankers, however, should keep in mind too caveats. First, eventually deposit rates will have to increase along with market interest rates. Second, eventually loan growth will slow. The Fed rate hike is not the beginning of accelerating earnings, but rather a one-time shot in the arms for community banks.