Thursday, August 18 , 2022 | Caroline Vahrenkamp, Program Manager, Raddon Research Insights
Two months ago, I wrote how the Federal Open Market Committee had increased the federal funds target rate three times already in 2022. Less than a month later, they had raised rates again, another 75 basis points, equaling the high water mark seen in 2018–2019.
The difference between these two increases, seen in Figure 1, is useful for understanding the impact this particular rate change has on Raddon’s profit model.
Source: Federal Reserve Board of Governors
In the aftermath of the Great Recession, I was chief financial officer of a then-$250-million credit union in Oregon. Every year, the National Credit Union Association would evaluate our safety and soundness, and in the process, we would get into disagreements about “rate-shocking” our balance sheet. They required us to demonstrate that we would maintain the net worth necessary to function if rates went up or down 100, 200, and 300 basis points. At the time, I was bothered by this requirement – rates never went up or down that quickly. Fast-forward to today, and 2022 has proved me wrong!
I could get deep into finance minutiae here, but since this blog is primarily read by marketers and executives, I’ll try to keep things simple.
The reason rate movement matters is that the three key elements of a financial institution’s balance sheet – loans, investment and deposits – all depend on interest rate. Loans and investments earn interest income based on rates. A deposit costs the financial institution interest, based on a rate. The rates on those products tend to be quite different, in size but especially in variability.
Most loans are fixed-rate. So, whatever rate was available in the market at the time the loan was made is fixed for the life of that loan. (Equity lines and credit cards are the typical exceptions; their rates can change monthly.) When market rates go down, borrowers tend to refinance their loans to get the new lower rate. When market rates rise, however, loans with low fixed rates now seem like bargains and tend to stay on the books much longer than expected, as people take their time paying them off.
Deposits, on the other hand, are mostly variable-rate. Their rates rise and fall because of market competition. (Term deposits are the exception; they keep a fixed rate.)
Why do changing rates matter in the Raddon profitability model?
As a CFO, I didn’t care so much about whether my deposits were profitable. They incurred an interest expense that I accepted as the cost of making loans and investments. I was focused on the overall net interest margin. That view works when looking at the institution as a whole, but when evaluating the profitability of individual accountholders or households, we need a different approach. There is real economic value in borrowing from a member at 0.1% instead of borrowing from the market at 2.375%, and we want to capture that economic value. Similarly, a loan made at 7.5% interest doesn’t strictly earn us 7.5%; if we don’t make that loan, we would instead invest those dollars.
This concept is called transfer pricing, and in most market conditions, it nicely divides the net interest margin into the margin for deposits, loans and investments. For fixed-rate loans and deposits, we use a blend of U.S. Treasury and Federal Home Loan Bank Board rates of similar duration to the product, and we use the rate that the market was providing at the time the loan or deposit was opened, since that was when the pricing decision was made. For variable-rate loans and deposits, we look at the current rate environment, because the pricing decision is being made in the present.
What happens to your balance sheet when market rates change suddenly? Nothing really, not until you raise or lower your offering rates. But when those market rates that we used for our transfer pricing move suddenly, it can have a massive impact on the profitability of individual households without affecting your return on assets overall.
Let me use an example, which I am keeping overly simple because I want to focus on the market rates.
Imagine a hypothetical household in December:
Now look at that same household in June, with the same balances:
On an individual product basis, core deposits are worth so much more now than they were, and variable-rate loans are worth less. Fixed-rate loans and deposits have not changed, because there is not a new pricing decision on those.
Now we have a problem: We tie the overall profitability back to the number reported in the call report. But the call report is historic (how much we have earned year-to-date), while our profitability is forward-looking (how much we will earn in the next 12 months). So, we have a mismatch: Deposits look more profitable because most are variable-rate, while loans largely haven’t changed because most are fixed-rate. That mismatch represents the interest rate risk inherent in operating a financial institution with long-duration assets and short-duration liabilities.
What this means is that an institution’s household profitability may look very different when rates change rapidly. But that is not a reason to adjust strategy. The keys to high performance remain the same: effective cross-selling, deepening relationships, adhering to your long-term strategy.
Quick changes in market rates will affect deposits more quickly than loans. Do not let the changes in profitability deter you from following your strategy.