Rising Rates Likely to Cause Some Rethinking

By Pat Allen

As long as there's limited volatility, all should be copacetic.

"It's different this time." This expression was last invoked by "irrationally exuberant" investors just prior to the bursting of the stock market bubble that led to the 2001 recession. These are the famous last words of those who believe that there is something so different about the current environment that it may escape the inevitable cycles in nature.

Fast forward to the recovery underway and to Edmond J. Seifried, an economist and scholar. Seifried suggests that the country is heading into a rising rate environment that may be different than that experienced in 1994-1995.

"The scenario is almost identical," says Seifried, author, consultant, faculty member of BAI banking schools and professor of economics and business at Lafayette College, Easton, Pa. The 1994-95 recovery was in manufacturing production but not in jobs. To control inflationary pressures, the Federal Reserve Board raised rates 300 basis points in 12 months. Such aggressiveness nearly drove the economy back into recession — and made life difficult for bank managers, among others.

But Seifried believes the Fed may have learned its lesson. Thanks to recent "immense stability," the 2001 recession occurred a full ten years after the 1990 recession. Long-term interest rates have been steadily falling for 20 years.

How would banks fare today if conditions turned volatile? In fact, the only indication may be through bankers' work in computer simulations at the banking schools. "Rapidly changing environments are where the students [banking professionals] really have their trouble driving pricing and profitability," Seifried reports.

But unlike a decade ago, Seifried is looking for rates to be increased slowly over the next 12 to 18 months and within a narrow band. Specifically, he expects a 150 to 200 basis point increase in short-term rates, and no more than a 50 to 100 basis point rise in long-term rates. As opposed to having a 7%, 8% or 9% prime rate, Seifried says, 7% might be a new ceiling.

Banks stand to enjoy a spread advantage as lending rates will head up almost immediately, according to Seifried. But while bankers may have some time before they need to hike rates paid on deposits across the board, it wouldn't hurt to dust off the playbook.

In serving as a safe haven for stock market refugees in the last few years, banks have enjoyed low- or no-cost inflows. Customers have suffered no opportunity cost by leaving balances in non-interest-bearing checking accounts. But, Seifried says, "As alternate rates rise, money will flow out."

Banks are likely to reverse the "de-CDing" strategy that many recently employed. As Seifried says, "With low rates as stable as they were and when you could get all the money you'd want for 1%, who wanted to pay 1.5% on a CD? I know bankers who told their retail managers to renew only good customers' CDs."

While banks relied on wholesale funds for inexpensive, day-to-day liquidity, Seifried predicts that rising rates will drive them back to CDs. And, he predicts a greater reliance on the retail network as a means of acquiring and retaining funds.

Taken together, Seifried expects rising rates to return banks to traditional banking: using branches to raise deposits, relying on CDs for funding and managing the margin. What's "different" this time, according to Seifried, is that life as a banker "should be easier."

Ms. Allen is managing editor of Banking Strategies.

Copyright © 2004 by Banking Strategies, published by BAI.

back to top