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Raising Rates Impact on Loans, Deposits

Contributors: Kevin Frank, CPA

The U.S. experienced it’s last recession following the 2008 financial crisis. The Great Recession was largely caused by over-exposure to sub-prime and non-traditional mortgages and mortgage-backed securities. While stringent controls and regulations have made the financial system less likely to experience a severe liquidity crisis, institutions must continue to monitor their overall condition and plan for the potential impact of a recession on loan and deposit growth.

A recession is defined as two consecutive quarters of negative real gross domestic product (GDP). According to advance estimates released by the Bureau of Economic Analysis at the end of October, GDP increased at an annual rate of 2.6 percent in 3Q 2022, an improvement over 0.6 percent GDP decrease reported in 2Q 2022.

That’s a positive trend. Yet, inflation continues to increase costs of goods and services. Rising interest rates mean more profitable loans, but they can also bring lower demand as borrowing costs increase. If the economy enters a recession, banks may experience a rise in non-performing loans as customers divert funds to pay other essential expenses, and an inability to repay due to rising unemployment. Related to commercial loans, a focus on CRE loan portfolios and their inherent risks, such as a drop in interest rates that would tighten profit margins or jump in non-performing loans as demand for a businesses’ products or services drop, are smart strategic planning priorities.

On the other hand, rising interest rates are likely to attract more deposits. Marketplace competition for those deposits is increasing as financial institutions carefully calculate profit margins to put their best rates forward without sacrificing earnings. For instance, CD rates started slowly increasing in February in response to lower treasury yields and expected Fed rate increases. More recently, average rates on a 1-year CD have doubled from 0.52% in July to 1.05% at the end of October.

What to watch for. Look for an inverted yield curve, which historically indicates a recession. The yield curve changes daily and an inverted yield curve occurs when short-term bond rates rise above longer-term bond rates. As of late October, the spread between three-month and 10-year bonds was 0.3 percent, up from 0.1 percent in late August, but well below the 1- percent spread seen in July 2022.

Start planning now. Scenario- planning, modeling, and revenue forecasting can help your financial institution avoid costly, urgent decisions that must be made in response to a rapid change in rates. Now is the time to anticipate potential economic changes and develop pre-emptive strategies, such as:

  • Hold on to current customers. It’s less expensive than attracting new customers. Ensure delivery channels are efficient and convenient, keep an eye on customer satisfaction scores, and reach out to customers now to deepen relationships.
  • Monitor the pipeline, value, and percentage of deals closed. An economic downturn could mean fewer leads and smaller deals. Empower management to push the sales team to be thorough in pursuing each opportunity to attract deposits and close loans. Talk with current loan customers to understand the impact changing economic conditions are having on their business or personal finances.
  • Understand your depth of people and other resources. Put a plan in place and prepare alternates to step in where and when needed to meet customer and shareholder expectations and to ensure you do not rely too heavily on any single individual for a smooth and efficient operation.