The Effects of Rising Interest Rates on The Financial System and How to Prepare for the New Normal

In a prescient February blog post, the St. Louis Federal Reserve cautioned that escalating interest rates could bring about both challenges and opportunities for banks. This foresight proved invaluable, as the subsequent weeks witnessed seismic shifts in the financial sector.

Silicon Valley Bank's abrupt failure, a mere month after the warning, triggered the most significant banking turbulence since the Great Financial Crisis. The reverberations were swift and far-reaching; Signature Bank plummeted, and a cascade of bank shares followed suit, sparking concerns about their solvency. A combination of Federal Reserve emergency measures, injections from the federal deposit insurance fund, and significant support from government-backed Federal Home Loan Banks helped to avert the looming threat of collapse.

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While the crisis has now abated, the St. Louis Fed remained steadfast in its cautionary note in May, reiterating that higher interest rates continue to loom as a potential threat.

The landscape of banking has been fundamentally altered. A sluggish economy, coupled with heightened regulatory scrutiny following recent bank collapses, has curtailed banks' ability to engage in high-rate lending. Commercial real estate loans and corporate loans, especially those with floating interest rates, are grappling with higher default rates.

The European Central Bank added its voice of caution in May, projecting a rapid decline in assets compared to loans for European lenders, particularly those that experienced turbulence akin to SVB. The central bank forewarned of a potential 4% reduction in book value for the average bank while also acknowledging that 25% of European banks might need to take corrective action if interest rates continue to rise.

In response to these challenges, banking giants like Citigroup and Goldman Sachs are reevaluating their strategies. A more discerning approach that examines each business line separately is replacing the formerly prevalent "supermarket model" of banking, which sought to offer a comprehensive suite of services.

The rise in interest rates has had a significant impact on banks' bottom lines. For a decade, banks thrived in an era of low interest rates and abundant, low-cost capital. Depositors, faced with meager alternatives, accepted nominal interest on their accounts. In an effort to attract clients and deposits, banks turned to internet banking and introduced fees for services like ATMs and account maintenance.

In early 2022, the US Federal Reserve responded to mounting inflationary pressures by raising interest rates. Consequently, the average US bank's funding rate surged from a mere 0.15% on its assets in the first quarter of the previous year to just under 2% in 18 months. The main cause of this was the increase in deposit fees, with some banks even offering 5% interest on certain accounts. Lending income, though experiencing a gradual uptick, still faces headwinds.

As the banking industry grapples with this new reality, adaptability and strategic foresight will be paramount. Navigating the evolving terrain of higher interest rates demands a reevaluation of business models and a judicious approach to risk management, ensuring that banks emerge from this period of transformation stronger and more resilient than before.