Are We Overheating?

Competition keeps us all honest, and it is a cornerstone of a healthy capitalist system. Institutions need to compete for depositors or members, as well as loans. We compete for deposits by trying to charge more than our competitors, and we compete for loans by trying to charge less than our competitors. Here, we can begin to see one of the inherent boom and bust cycles a competitive capitalist system drives. Rates on deposits will go up and rates on loans will go down, until this creates a crisis where competitors struggle to exist. This makes institutions increasingly fragile, and the headwinds of a recession may lead to a series of failures, which then allows the survivors to reset the status quo with lower deposits and higher loan yields again.

What I experienced in Washington DC some three years ago, appears to be arriving in the Midwest with a vengeance. To beat competition, institutions are bidding increasingly low interest rates for increasingly longer terms. There are two key issues I worry may be overlooked in this race to provide the most competitive interest rates. These are two distinct issues, the first being that each institution has a different cost of funds and hedging profile, and the second issue has to do with the Federal Reserve’s desire to push interest rates upward.

Addressing the first issue of hedging and cost of funds, I think we need to acknowledge that not all banking balance sheets can be compared apples to apples. More institutions are increasingly purchasing derivatives, so they can convert the risk of fixed rates to be on par with that of variable rates. An institution that buys these derivatives can offer lower fixed rates because they will be less affected by rising rates. However, if your institution is not buying derivative hedges to mitigate rising rates, you are taking more risk by competing with lower interest rates.

The second substantial issue is the desire of the Federal Reserve to increase rates. They initially wanted to raise rates four times this year, which presumably means an annualized increase of 1.00%, since each increase is expected to be 0.25%. Although, where we are sitting in April, many have reason to believe they might realistically only try for two times, amounting to a 0.50% increase. Now, consider that your institution needs a 2.50% spread between loan rates and deposits to remain operational. If a loan is fixed for 5 years at 3.50%, then you are hoping that the cost of your deposits does not increase by more than 1.00% over the course of those 5 years. And note, the Federal Reserve wanted to raise rates by 1.00% in just 1 year alone! If the Federal Reserve raises rates any more for the remaining 4 years, that is arguably a loan you are losing money on.

I remember when reading Jack Welch’s book Winning, that he discussed “deal heat.” People get worked into a frenzy when they desperately want to make a deal happen, and they find themselves making compromises and concessions they later regret. I suspect right now there is a lot of “deal heat” seeping into all areas of business lending, and I worry it is starting to feel like the system is overheating a bit.