Time to Talk Interest Rates

Interest rate hikes are (finally) on the horizon. How should banks adjust their 2022 strategies? Will an increase in commercial loan demand follow? And when the funding costs rise, will pricing move up as well? 

  

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Questions? Comments? Email Jim Young at jim.young@q2.com

Transcript:

Jim Young:
Hi, and welcome to The Purposeful Banker podcast brought to you by Q2 PrecisionLender. We discuss the big topics on the minds of today's best bankers. I'm your host, Jim Young, Senior Content Strategist at Q2, joined again today by Dallas Wells, Head of Product at Q2. Today's topic is one that's old as well... It's at least as old as banking, and that's interest rates. More specifically, they're going to, at least believe, going to go up in March. What exactly does that mean? Dallas, thanks for coming on the show.
 
Dallas Wells: 
You bet. Thanks, Jim.
 
Jim Young:
All right. Well, let's start off with, as we often do here, with a simplistic non-banker question from a simplistic non-banker person. If you're a commercial banker and I tell you, Dallas, the Federal Funds Rate is going to go up at least 25 basis points in mid-March. You are, A) happy, B) sad, C) excited, D) scared, E) none of the above?
 
Dallas Wells:
Yeah. I like the multiple choice on a podcast. That's a good format for us, Jim. Probably some combination of those, but maybe just relieved, I mean, at this point. It's a broad generalization but, generally, higher interest rates, at least higher than where we are now is a good thing for banks. The oversimplified explanation of that is funding costs have a floor, or at least a practical floor, at zero. But the yields on assets have just continued to come down. With rates near zero, they squeeze towards that same lower bound, and it just squeezes all the margin out of the business. Especially, for community and regional banks that are just very heavily credit spread dependent, it's been a rough couple years. The longer we stay at those compressed levels, the entire balance sheet rolls over at that kind of pricing and it's difficult to drive the kind of earnings that banks need.
 
You've seen the indication that that's not just me pontificating, is you've seen bank stock prices do pretty well, especially relative to the rest of the market. That's because while higher rates may be bad for debt laden or tech companies or whatever, it's pretty darn good for the banking sector. All in all, this is good news but it does mean that there's some things to work through.
 
Jim Young:
Okay. Interest rates get bumped up to combat inflation. Before we dive sort of really more into the interest rates part of this, let me just back up and just ask a question regarding inflation. Should we expect this then to lead to an in increase in commercial loan demand then, given the market conditions as they are and as we expect them to be going forward in 2022?
 
Dallas Wells:
Yeah. This one, I think's a little tougher question just because it's been a very long time since we've seen real inflation, especially inflation at the kind of rates we've seen over the last couple of prints of that number. These are levels we haven't seen since the '80s. And so, there's not a whole lot of bankers around that have had to actively deal with inflation, and the world's a little different than it was 40 years ago. We will see exactly what that means now. Just, logically, businesses are facing the same sorts of issues that everyone else is, inputs cost more and, therefore, working capital needs are higher. There should be, and has been, an increase in demand for commercial lending.
 
It's a little bit inflation. It's a little bit just where we are in the cycle and where we are post pandemic, as more and more businesses get back to some semblance of normal. You're seeing just activity pickup and, therefore, lots of new projects that need to be financed, lots of new lines of credit that need to be used that weren't being used before. Again, overall, yeah, increase in loan demand and the ability to maybe effectively price in some spreads. Those first two things are checks in the positive column for the industry.
 
Jim Young:
All right, good. Well, you set that up really well because I'm about to pivot to something that doesn't seem quite as positive, at least on an early return sort of thing. Well, actually, before I do that, I mean, I'm getting ahead of myself here. But first, want to go back, Anna-Fay Lohn came out with her first commercial loan pricing market update of the year, taking a look at January data, and funding costs were already bumping up a significant amount in January. That's again, before we've gotten this Fed Funds expected, anticipated Fed Funds increase. Is this sort of pricing in where, essentially, banks are just sort of assuming this is where we're going to be headed, so let's go ahead and start pricing it in at this point in terms of funding costs?

Dallas Wells:
Yeah. Really what she's measuring there is the funding curve that gets used as we look at how banks price those deals.

Jim Young:
Right.

Dallas Wells:
And so, it takes the yield curve and it kind of takes the portion of each deal that gets put together, the portion where it goes on the curve, and prices it accordingly. What that means is that the market has been anticipating that these rates will increase. And so, you've seen out on the curve, especially, and really in kind of the belly of the yield curve, those yields have gone up quite a bit. In fact, there's been a fair bit of volatility there. We've seen the 10 year go through 2%, again for the first time in a while. That's moved all the way back to the two year part of the curve.

What that means is that big chunks now of those deals that banks are putting together are being priced out in a more expensive part of the curve that is anticipating those higher interest rates. Really, that's telling banks what it should be telling, is when you are pricing these deals and evaluating them, make sure you do that knowing that expectation that the market has, that rates two years from now will be higher than they are today and you need to be compensated for that.

Jim Young:
All right. Now, to the part that I teased. A little got ahead of myself here. In that same review, that Anna-Fay had, yes, funding cost had bumped up a significant amount. The big thing was, hey, pricing finally on fixed rate deals got off of that 3.5% coupon, but that coupon increase wasn't nearly as much as the cost of fund increase so, shocker, fixed rate margins fell again. I think it's down about 40 basis points over the last four months here.

Am I being negative here maybe, and tell me if I've got recency bias? But I feel like every time I've seen one of these cost of funds increases, it feels like there's a lag before there's a corresponding price increase and there's this point where banks sort of, what you would call it, leave money at the table, I'm not sure. But they have this point where, in theory, you'd say, "Okay, funding goes up this much, we can increase pricing that much," but they don't seem to, and so there's this margin compression. Is that just the way it always is or am I, again, having recency bias?

Dallas Wells:
No, it doesn't just feel like. That's the way it is and it's largely the way it all always has been. Especially, as a part of the cycle that goes into this, the business cycle. Almost always, when you're coming from this place of low rates, that means you're coming from some place of compressed business activity where the cycle is down. And so, again, most of the time you're seeing banks with not enough loan demand and so there's brutal competition for the good solid credits that are there, between just less demand and less willingness to take on risk from the banks themselves.

Then, as rates start to rise, that's indicating that we're coming out of that. And so, the funding costs do start to increase. They to get a little higher. But you've got banks that, as that's happening, they've got a lot of excess liquidity. Sometimes they're licking wounds from some losses they may have incurred. And so, it's a question of in the marketplace who wants to blink first and actually be the one to say, "You know what? That deal that we just priced last quarter, well, this quarter, it's a quarter point higher, or it's a half a point higher." Afraid that they will lose that to those that are willing to sit on it and drag their feet a little bit.
It's a little bit of a game of chicken, between all the various competitors in the market for a deal. And so, it takes some time for those prices increases to really work their way through.
It's going to be largely just balance sheet makeup and what strategy is being used by an individual bank as to how soon they actually start actually incorporating those prices. What you're seeing is it's true, it's compressed margin, and it's basically banks saying, "We're willing to take a little bit of compressed margin to keep winning some of these deals." At some point, that margin compression will get to be too painful to bear and they will start to pass through some of that funding cost increase to the actual borrowers. It's happening, but it's slow and that's pretty typical. It'll just take some time to filter its way through.

Jim Young:
Yeah, I guess I wonder, this is going to go really old school, but this feels like the conversations that we used to have with banks five or six years ago when talking about PrecisionLender and that whole thing of the other bank, the crazy bank across town, that when you were talking about playing chicken, this sort of reminds me of that whole thing of them complaining about. "Look, I get it. I understand what you're telling me what I should be doing and what PrecisionLender software is telling me I should be doing if I want to get the ROE that my boss has told me, I should be getting, but bank X over there is still driving their car at 100 miles an hour straight at me on this one lane road, so what am I supposed to do here?" I guess that's what I'm wondering is do you just say, "Well, okay, just keep on driving. Trust us, this thing will eventually move," or what?

Dallas Wells:
Yeah, it's tough. There's the old saying there if you're only as smart as your dumbest competitor and, in some places, that's not very smart. That's what you have to be really careful of. I think in the grand scheme of things, and especially now, just as fast as information moves, as fast as markets move, I think there's less need to wait out every other institution in the market. Also, there's not as much pricing transparency as you might think. Everybody thinks, "Oh my gosh. If we raise our fixed rates on these five year deals that we're doing by a quarter point, demand's just going to dry up. We'll never book another deal." Well, that's not really true. It's not like you're a gas station and these prices are posted on a billboard outside. They are probably for your mortgage rates, but not for these complex commercial deals so you probably have more room than you think.

I think this is really where you have to get, if that's the mentality, if you are really that caught up in where the other institutions have their interest rates on a deal, it's just one lever in many that you have to pull. If you're really about relationship banking, like most institutions claim to be, there's lots of ways to win the deal. And so, rate is but one. It's just the simple one. This is where you really do see a differentiation. And so, you mentioned that those fixed rate coupons were starting to come up and that's because it's a few early movers pulling those averages up and then a whole bunch of laggards doing nothing.

Those early movers, their results look better and, more importantly, they will look a lot better 12 months from now when funding costs have moved even higher and those overnight rates are now higher because the Fed has commenced on their cycle. It looks a little painful now. It could actually look worse a little bit down the road. That's what using the yield curve to price is really telling you is where should you be so that you're ready 12 months from now, 24 months from now? And so, that's a long way of saying I think it's worth starting to move on this. Of course, there's going to be deals that are competitive and you know they're actively shopping it.

My advice would be to price it where you should price it and then bend when you need to. Instead of just assuming, "Well, I have to bend on all the deals. I'm not moving my pricing yet." follow the math. Follow the yield curve. Price it where it should be priced, and then you should be establishing the relationships with these customers where, if you're a half point higher because you moved sooner, they should tell you that and you should find a way to overcome that. If it takes just matching it to win the deal, at least you consciously did it on the deals that you really had to, and not just across the board out of fear. The industry hasn't caught up to that approach yet, but I think it's the right one.

Jim Young:
Yeah. That's what I was wondering when you were talking about there's not as much transparency, again, across the industry as maybe we would think. It sort of tripped in my mind, the idea of the transparent one on one conversation and do you think it's a situation where... Would it be well received by a customer if you said, "Listen, hey, you see and understand the Fed Fund Rate. Cost of funds are going up for us now, which means I'm going to have to transfer some of this to you essentially. Your coupons are going to go up and this is why." Or do you think a customer would say, "I don't care. I just don't want it. I want it at 3.5% like it was last year."

Dallas Wells:
Those are the sorts of conversations you should be having with your customers. Again, in a commercial relationship, they're generally sophisticated enough, they understand. It's probably not going to be a surprise to them. But you should be saying, "Hey, rates are up from where they were last year. Here's the rate." Not just the rate but, "Here's all the pieces of the deal. Here's how we think this deal should be structured. What do you think?"

If what they think is, "Well, I already shopped this around town and this is 50 basis points higher than whoever else." Now you know the conversation. Now you know what you're competing against. Let's get really specific about that and the only way you know is clear, open communication and putting the number out there where it should be. If you are afraid that they're just going to ghost you because they got a better deal, well, then you don't have a great relationship there. You don't have a path to a really good profitable relationship with that customer anyway and those are the sorts of problems you need to solve with your sales force. Not where your rates are, but how are they actually negotiating these things and how are they building these relationships over time?

Jim Young:
Got it. All right. The deposits part of this conversation and, normally, I'm thinking increase in interest rates means, hey, increase in deposits, more attractive place for me to park my money. But as you and I have discussed ad nauseum, a lot of money got parked already in the last couple of years. I guess, honestly, on both sides of this, I started off thinking about it from a business point of view, which is I've already parked all my money at this point, practically. Do banks even want to take them, or I guess on the flip side of that, is this a case where you could start... I'm just thinking through this, you could raid some deposits from another, but do you want them. I'm just kind of curious at this point.

Dallas Wells:
Most institutions have no need for them right now. If you look at just as a straight funding question. Do we need liquidity to be able to loan it out? The answer is no, not yet. We have a bunch to work through. We've grown our cash balances. We've grown our securities portfolio. Both of those can be sort of worked down and that can be your source of funding. If you actually have a big pickup in loan demand, you can kind of right size your balance sheet back to where it should be. There's need for that. But there may be a need for using this as an opportunity to go proactively gain some customer relationships, and that's where you need to be targeted about it. Should you take your savings account rates up step for step as the Fed raises rates?

Well, of course not. It's the same concept as on the loan side. You're giving across the board pricing as if everyone is price sensitive when the vast majority are not that price sensitive. These are tricks of the trade in deposit pricing that may be a little rusty for a lot of bankers. They were just getting back to figuring out what some of these tactics were following the financial crisis when here we were back again with the pandemic and the rate response to that from the Fed. If you take those things together, you got to go all the way back to, gosh, 2007, before we were used to real rate movements of any size to where they mattered on the funding side.

If you think about how the world is different between 2007 and now, back in 2007, we were still talking about running CD specials, and that's how you identified rate sensitive customers and moved hot money, rate sensitive money, from one place to another without pricing up the entire deposit base. I think the tactics are going to be... The concepts are still the same, but how you actually go about doing that's going to be a lot different than it was the last time you may have had to do this. I think it'll be interesting to see how the market approaches this. What the higher rates do give you though is the ability to use rate as a way to go get new business in some way, shape or form. We saw this happen before the pandemic and before rates got cut, you saw some institutions being really aggressive with rate and raising deposits with it, but also new customer acquisition with it.

Banks like Ally or Goldman through Marcus, they had these all digital platforms where they were going out and finding, in a lot of cases, high net worth prime target customers, but they were paying, I don't know, a hundred basis points more than the national average on savings accounts balances. They had an outlet for that money. If they raised a bunch of money, if they couldn't loan it all out, they could put it out into the securities market and they could break even on it still. They had an outlet to where they didn't just have to eat a bunch of that rate. This kind of puts that ability now back in the toolkit, again, where you can selectively go after certain customer segments and try to build new relationships and you have a way to differentiate. You can use price as a weapon to proactively grow. I don't think anybody needs to defend a deposit base just yet, but if it's playing offense instead of defense, that's a possibility.

Jim Young:
Okay. That sort of feeds into the final question I've got here, which is, I know these are projections and we've had conversations about that, but general consensus says is that this is the start, this next hike, will be the start of many. It's going to be kind of a rolling set of hikes throughout the coming months. If you're a commercial bank, do you... Or I guess, you'd probably already, I'm assuming, set your strategy for 2022 with that in mind, and how does that sort of alter it, beyond sort of what you've already discussed?

Dallas Wells:
I think maybe the difference is that when those plans for '22 were made, there was an assumption that rates would be increasing. Since then though, the inflation numbers have come in higher than expected, and consistently and across the board higher than expected. The word that was being used at the end of last year was that, "Well, this is transitory." That was the Fed's word for it, of it's temporary. It'll work its way through the system and don't sweat it. Well, some of this doesn't feel so transitory anymore. Even the Fed in their remarks and speeches and the hints that they try to give to the marketplace, they seem a little spooked and maybe it's not so temporary. The one lesson that, I think, everybody can take again from the last time we saw this way back in the olden days of the 1980s, is that inflation's not to be trifled with.

And so, if you're concerned about it, you nip it in the bud aggressively, and so I think that's the hints of what you're seeing from the Fed is not just that, "Hey, there's going to be a series of a quarter point moves and the question is just how many?" But now, there's the question of like, "Hey, do we do some bigger hikes here? Do we do some between meeting hikes? Do we move 50 basis points or more at a time?" None of those things were baked into the bank's models for this year. You mentioned the lags. By the time you introduce not just more moves, but maybe faster and maybe more aggressive moves, and then you factor in the lags and who moves when, it adds some complexity and some volatility to a core piece of the business that probably makes some bankers a little nervous.

Again, it's not an element that they're used to dealing with. It's sort of been credit risk and technology is sort of the two big, giant things that they've been wrestling with, and now you have to add this rate volatility question to that and how does it interplay with the other two? I'm sure there's been some interesting discussions around this in every boardroom around the country. Do you adjust your strategy? I think so. You have to kind of take both sides of it, like always with banks. You have to look at what extra risk does this introduce, and then also what opportunities does it give us?

We started out the podcast, I think net net. All in, even with the rates moving maybe a little faster than expected. That's all a positive outcome, and there's more opportunities than there are risks being surfaced from this. I think what banks need to do is say, "Hey, these kind of opportunities don't come around all that often, where all of a sudden we've got room to be an early mover and maybe an aggressive mover and steal some market share somewhere."
Banks need to be thinking about how to take advantage of that. I think what it's going to be is a combination of using rates as your tailwind and technology, using those two things combined to be really targeted, to win the kind of business you want to win, and also reintroduce maybe some spreads and margin back into the business as you go. Fun times, and I think, as always when there's volatility and big changes, we'll see some banks start to separate themselves and the others generally end up for sale is kind of the way it goes.

Jim Young:
Yeah. I was going to say sort of the summation here is not to diminish the interest rate conversation, but it's almost more that it's not the interest rate part, that it's a market shift, whatever that market shift is. When it shifts, it's the ones that can recognize it, move more quickly and figure out how to capitalize on it that move ahead.

Dallas Wells:
The bottom line is that, as rates move, you've got some customers that are all of a sudden going to start thinking about, "Hey, am I at the right bank? Do I have my deposits in the right place? Am I borrowing from the right place?" And so, you need to make sure that you are positioned right when those questions come around, to save the customers that need saving and pick off the ones that you'd love to pick off. This is your opportunity to do that so it should be interesting to see how it plays out.

Jim Young:
All right. Well, Dallas, thanks again for coming on the show.

Dallas Wells:
Yeah. Appreciate it, Jim. Thank you.

Jim Young:
Thanks again so much for listening, and now for a few friendly reminders. You want to listen to more shows you can go to the Podcast Page at explore.precisionlender.com, or you can head over to Q2.com to learn more about the company behind the content.

If you like what you've been hearing, please make sure to subscribe to the feed and Apple podcast, Google Play or Stitcher. We love to get ratings and feedback on any of those platforms. Until next time, this is Jim Young, Dallas Wells, and you've been listening to The Purposeful Banker.

About the Author

Jim Young

Jim Young, Director of Content at PrecisionLender, is an award-winning writer with experience in a range of positions in media and marketing, from reporter to website editor to content marketer. Throughout his career Jim has focused on the story – how to find it, how to understand it, and how best to share it with others. At PrecisionLender, he manages the many ways in which the company shares its philosophy on banking and the power of relationships. Jim graduated Phi Beta Kappa from Duke University and holds a masters degree in journalism from Columbia University.

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