4 Approaches to Adapting to a Prolonged Higher Interest Rate Environment

Operating in today’s higher interest rate environment is a constant balancing act for U.S. banks, credit unions and other financial services institutions, but it is a tightrope they will continue to walk for the foreseeable future.

While the Federal Open Market Committee (FOMC) has slowed the pace of interest rate increases in 2023, its efforts to tamp down on inflation are far from over. The committee raised interest rates another quarter of a percentage point at its July 2023 meeting after opting to make no increase in June.

The July hike brought interest rates to their highest level in 22 years. It marked the 11th increase in the past 12 FOMC meetings, including four consecutive three-quarter point increases in 2022 followed by a series of half-point increases in late 2022 and early 2023.

Federal Reserve Chairman Jerome Powell said core inflation remains “pretty elevated” and the committee could increase rates again before year’s end. “Inflation pressures continue to run high, and the process of getting inflation back down to 2% has a long way to go,” he said at a Bank of Spain conference in Madrid in late June.

A Balancing Act

Ninety percent of U.S. financial institution leaders agree that changing interest rates are the biggest driver of business model shifts in 2023, a recent Syntellis survey found. According to conventional wisdom, net interest margins and hence overall profitability increase as interest rates rise, but the impacts of a prolonged high-interest-rate environment are much more complex.

Such environments tend to be more volatile as factors such as high inflation and unstable economic growth negatively affect outcomes for financial institutions. Higher interest rates can lead to higher lending rates while deposits lag. Borrowers’ credit quality can suffer as they struggle to repay loans at higher interest rates. As rates remain high, borrowing slows as businesses and consumers grow increasingly wary of taking out new loans. Over time, a significant share of balances can shift from non-interest-bearing demand to higher-yielding time deposits and other longer-term liability products.

In the survey, 88% of finance leaders nationwide predicted commercial loans would be the greatest area of profitability growth throughout 2023, and 60% anticipated growth in wealth management income as primary sources of non-interest income change throughout the year.

Financial institutions need to build agility and resilience to navigate ongoing shifts in these tumultuous times. Finance leaders should take a comprehensive approach, including assessing all potential risks and returns associated with changing economic conditions.

Here are four tips for adapting to a pro-longed higher interest rate environment:

1. Identify new sources of non-interest income. Non-interest income from various sources – such as wealth management, service charges, loan fees and credit card fees – has grown increasingly important in recent years, contributing a larger share of institutions’ total income. As demand for mortgage refinancing and other loans slows with higher interest rates, income from related fees decline. Regulatory pressures targeting overdraft fees and other so-called “junk fees” mean further declines in traditional sources of fee income. To offset those losses and grow profit margins, finance leaders should look to maximize non-interest income through new sources, such as growing interchange income that merchants pay for their customers to use credit cards.

2. Leverage market data and analytics. Banks, credit unions and other financial services institutions can leverage the data they collect from customers to monitor market trends, better understand revenue dependencies, find new revenue sources and ensure smart investment decisions. Finance leaders should maintain a future focus by embedding data and analytics in strategic decision-making processes, including routinely testing what did and didn’t work, and modeling new scenarios to determine the best strategies moving forward.

3. Leverage loan and deposit pricing benchmarks and projections. When interest rates are high, finance leaders should pay special attention to data and analytics related to loans. With modern analytics capabilities, financial institutions can monitor fluctuations in loan demand and average loan prices within their markets at a summary level, or drill into the department, service or individual transaction level. Such insights allow institutions to stay competitive as finance leaders better manage loan offerings and pricing.

4. Understand pricing and profitability. By analyzing pricing and profitability down to the individual branch, product, account, customer or relationship level, finance leaders can understand which areas of the portfolio are driving the most value for the institution. They should generate profitability models that factor in funds transfer pricing, cash flows, interest rates, product-based fee income, costs and capital requirements. With this kind of comprehensive view, institutions can guide sound, real-time decisions to ensure competitive pricing and incentivize profitable growth.

As the financial services industry continues to feel the long-term effects of higher interest rates, finance leaders must remain vigilant and adapt their institutions for shifting market forces and a slowing economy. Assessing an institution’s current revenue mix and understanding revenue dependencies is more critical than ever as finance leaders work to stay ahead of market changes, diversify revenue streams and build new sources of profitable growth for their institutions.

Eric Wheeler is Director of Product Management for the Chicago-based Syntellis Performance Solutions.