What the Fed Rate Hike Means for Banks

WASHINGTON — The Federal Open Market Committee on Wednesday voted to raise federal interest rates from nearly zero for the first time since 2008, meeting market expectations but ushering in a new and uncertain normal for the banking industry.

The Committee voted to raise rates 25 basis points — to between 0.25% and .5% — with 11 voting in favor. Two FOMC members apparently preferred to keep rates at the current zero lower bound, as indicated by their so-called "dot plot" of preferred rate levels. Those members did not dissent the decision, however.

The committee approved the historic hike despite slight downward projections for inflation in 2015 and 2016, perhaps encouraged by slightly increased projections for GDP in 2016, up to 2.4% from 2.3%.

Federal Reserve Chair Janet Yellen said that the committee decided to raise interest rates because of gains in the labor market in 2015, the expectation that headwinds from cheap energy prices and imports will dissipate over time, and that economic growth will continue "to expand at a moderate pace".

"The stance of monetary policy remains accommodative after this increase, thereby supporting further improvement in labor market conditions and a return to 2% inflation," Yellen said. "The committee expects that economic conditions will evolve in a manner that will warrant only gradual increases in the federal funds rate; the federal funds rate is likely to remain, for some time, below levels that are expected to prevail in the longer run."

The committee's expectation for the timing of the federal funds rate's gradual rise was roughly in line with market expectations. Seven of the committee members preferred a rate of between 1.25% and 1.5% by the end of 2016, though another seven members envisioned lower rates. Committee members had a far wider spread of opinions for year-end rates in 2017, with suggestions ranging from just under 2% to 3.5%. Twelve of the seventeen members expected a longer-run rate of between 3.25% and 3.5%.

The announcement was not unexpected. The day before the FOMC made its announcement, interest rate futures markets were estimating a roughly 80% probability that the Fed would raise rates. Yellen and other FOMC members made strong indications in speeches leading up to the meeting that the committee's longstanding conditions for raising rates — a stronger labor market and more signs of inflation — appeared to be materializing.

But banks see the rate hike as something of a mixed bag. On the one hand, financial institutions have been calling for a return to more normal interest rates because it means a return to a more stable and predictable core business model. But on the other, higher rates could have an unpredictable effect on already-temperate loan demand.

James Chessen, chief economist at the American Bankers Association, said the initial rate increase is going to be harder on the Fed than on the economy, because once the initial hike happens it signals that the die is cast. Rates will steadily, gradually rise over the course of probably the next three years or so to reach a normal rate of around 3%. But the more important issue is the legacy of the Fed having kept rates so low for so long that the yield curve for banks' lending activities is likely to flatten while borrowers will probably continue to demand low interest rates for very long terms.

"The yield curve will no doubt flatten and that has its own stresses for banks as they try to meet the needs of their borrowers, who want to go as long as they can for as low a rate as they can," Chessen said.

Chessen added that raising rates — even beyond the initial increase — probably won't give banks much of an edge against shadow banks in terms of earning back some of the market share in consumer or mortgage lending, but it could improve banks' edge in commercial and industrial or small business lending. The bad news, however, is that there isn't enough business lending to go around, and competition is already fierce.

"Where it does make a difference is in the bread and butter products or loans from banks, which is the business lending, where it's not a plain vanilla product and there's more flexibility there in terms of the contract and the evaluation of the risk and the term of the loan," Chessen said. "And there's no shortage of competition right now — within the banking industry, let alone the nonbanks — for making those loans, and given the environment, the low rates … that's a challenge. Without a pickup in loan demand that will continue to be a challenge to generate that top-line revenue growth."

Banks have different opinions on whether the rate increase will help or hurt loan demand.

Bob Braswell, CEO of Carolina Bank Holdings, said that any chilling effect from rate hikes "depends on pace of increases," where a sudden or haphazard series of hikes could affect markets but a steadier increase could provide "opportunities" for bankers.

Scott Anderson, chief economist with Bank of the West, is more pessimistic, saying that there will be some chilling effect in loan demand, particularly for big consumer purchases, but growth will probably remain moderate next year.

"Mortgage rates will start moving higher. That's going to take some of the expansion potential away from 2016," Anderson said. "Some of these big ticket items, like autos and houses, you might see relatively bigger impacts. [Borrowers] are used to very low interest rates."

Lawrence Yun, chief economist for the National Association of Realtors, said that increasing rates — especially by such a trivial amount — could act as a stimulant to the economy by signaling to the markets that the Fed thinks it is growing at a steady and reliable pace and can handle a slightly tighter monetary policy. Anyone who was going to borrow in 2016 isn't going to defer because the Fed raised rates by 25 basis points, he said.

"The raising of short-term rates could be more of a confidence play to the market — it provides a signal that the economy is strengthening, and to the degree that the Federal Reserve is providing [that signal] and the lenders believe that, it may actually provide more lending opportunity for the banks," Yun said. "As a borrower, even for the short-term borrower, what difference does it really make whether one is borrowing at 0.1% or 0.2%, when the Fed Funds Rate is historically at 3.3% or 3.5%?"

Part of the question for banks is not only whether rates go up, but also what methods they use and how those methods interact with regulators' new regulatory capital and leverage requirements.

As expected, the FOMC voted to raise its interest rates on required and excess reserves to 0.5% as its primary means of raising short-term rates. It also instructed the Open Market desk at the Federal Reserve Banks of New York to execute overnight reverse repurchase operations, at an offering rate of 0.25%. The FOMC also voted to increase the discount rate by 0.25% to 1%. All of these changes will be effective Dec. 17.

The Fed opted not to change its policy of "rolling over" its holdings of longer-term securities when they reach maturity and reinvesting principal payments from its holdings of agency debt and mortgage-backed securities, "and anticipates doing so until normalization of the federal funds rate is well under way," Yellen said.

Ernie Patrikis, partner with White & Case and former Vice President of the New York Fed, said the decision to raise the interest rate on excess reserves poses an interesting problem to banks — they can get a better rate of return by keeping more of their money in reserve accounts, but that money would count against its leverage ratio, perhaps making it unattractive.

"In the old days, when the FOMC wanted to tighten, it would sell assets," Patrikis said, speaking before the decision was announced. "Or will it increase interest rates on reserve accounts to encourage banks to put money with it? That doesn't hurt them in terms of capital adequacy, because funds in a reserve account have a zero capital charge, but for leverage it affects them. The issue is, do you stay the same for leverage? Do you increase your leverage?"

Patrikis also said something that the Fed should consider is using its regulatory capital minimums as a tool of monetary policy. The central bank could temporarily reduce capital reserve requirements in times when banks need stimulus and raise them again as a countercyclical measure when they get too hot. That would be an easy way to get more money out of the banks, though not as likely a popular one with regulators.

One of the leading concerns from some analysts is the potential for rising rates to trigger interest rate risk — a situation where banks suddenly owe more money to finance their deposits than they are taking in from loans. On Tuesday, the day before the FOMC announcement, the Office of Financial Research issued a report that called interest rate risk "historically high" and warned that if the FOMC is unable to raise rates slowly and gradually, it "could threaten financial stability."

Yellen said during a press conference following the announcement that the Fed has monitored interest rate risk as part of partnerships with community banking organizations and among larger banks through the annual stress testing process. For each of the past three years, the stress scenarios have contemplated interest rate increases that are far more severe than anything the central bank intends to undertake as it normalizes rates, and those banks have passed those scenarios, she said. Nonetheless, it is an issue the agency continues to watch.

"This is something we have been monitoring very carefully for a very long time," Yellen said. "This has been very much on our minds."

Comptroller of the Currency Thomas Curry echoed those concerns in remarks to reporters on Wednesday morning, before the Fed made its move.

"Interest rate risk is another area where we are paying very close attention, even as the FOMC prepares its announcement regarding rates this afternoon," he said. "Interest rates have remained at historic lows for an extended period, and bank earnings could be affected negatively if short-term interest rates rise relative to long-term rates."

Patrikis said he expected that those products that are more closely tied to the federal funds rate — checking, savings and CD accounts, for example — are likely to see rates rise nominally as interest rates increase, which may affect some smaller banks. But James Wilcox, a professor at the University of California — Berkley Haas School of Business, said that it could be helpful to smaller institutions.

"Often we might think about mini-banks having interest rate risk and that rising rates might ultimately, in the short run, be kind of painful," Wilcox said. "I think in the current circumstance, that's not likely to be the case. And given where we've come from, if anything I wouldn't be surprised if net interest margins tend to improve for quite a while."

Wilcox said that for larger banks, much of their revenue comes from business loans, which effectively have floating interest rates that will now begin to bring in more revenue that will probably offset any increase in deposit interest.

Additionally, since the federal funds rate has been at zero, banks have actually been paying out higher dividends on checking and savings accounts than they should have, he said. Negligible though those rates have been, many banks were losing money, so the crush to boost returns on deposits — and the potential for depositors to flee their banks for better rates — may not materialize for some time.