Another month has come and gone, another month when the Federal Reserve passed on the opportunity to raise interest rates. Other than Peyton Manning it’s hard to think of anyone who passes more often than Janet Yellen, the Fed’s chairman.
“In the scope of the U.S. economy, tinkering with the federal funds rate is a big deal — the higher it goes, the more expensive borrowing becomes,” explains Yahoo! Finance. “That’s because many lending institutions look to the fed funds rate to determine where they should set their interest rates.”
Actually, though, the traditional definition of a Fed rate hike may well be in transition. While the Fed directly impacts borrowing costs for banks it does not set mortgage rates. More importantly, it may be that even the Fed’s monopoly grasp on bank interest rates has begun to loosen and that’s why the Fed is not raising interest levels at this time even though many argue that such an increase is long overdue.
Nonbank lending institutions increased their market share of agency purchase mortgage originations from 27 percent in mid-2012 to 48 percent in late 2014, according to a study from Harvard’s Kennedy School. In the world of auto financing, nonbanks provided loans and leases for 7.6 million car buyers in 2013. And credit unions, depository institutions not regulated by the Fed, are growing much faster than traditional banks.
According to second-quarter research conducted by Callahan & Associates, “credit unions increased their loan portfolio 10.6 percent as of June 30, 2015, compared to 5.4 percent for banks. By loan type, credit unions posted 8.2 percent growth in real estate, 15.4 percent growth in auto, and 6.8 percent growth in credit cards. Banks posted 4.4 percent, 7.2 percent, and 2.2 percent growth, respectively. Auto loans accounted for 32.9 percent of the loan portfolio at credit unions and 4.7 percent of the portfolio at banks.”
The growth of nonbanks raises a problem for the Fed: If it raises interest rates it’s risking making client banks less competitive. Not only that, it opens the door to something very different, the possibility that some “banks” will no longer want to be banks and thus under the Fed’s authority.
Even as the Fed considers higher interest rates the world is flooded with capital. In Europe and Japan an estimated $3.6 trillion in government bonds carry negative interest rates. Mortgage rates in the U.S. are now around 4 percent even though the real estate industry is seeing substantial sale increases. Why? In part because there is a massive capital surplus, a surplus which in some measure comes from foreign money seeking a safe haven in the U.S.
Let’s imagine that the Fed raises rates by .25 percent in October or December. The market will instantly react with higher rates. But once the initial rush of rate increases is announced what happens then? When the Fed ended quantitative easing in October 2014 mortgage rates rose before termination — and then fell once again within a few weeks.
Part of the reason for the lower rates is that Fed-regulated banks are not the only source of capital. Nonbanks get some of their money from banks, but they also get cash from investors and by issuing debt. If bank rates go up there are alternative sources of capital available.
Not only might a Fed rate hike reduce bank borrowing, it could also increase nonbank margins. If banks have given costs and nonbanks have lower costs, then nonbanks have very little incentive to lower mortgage rates below the rates charged by commercial banks. If they just go along with the rates charged by banks they can reap substantial profits because without a deposit base or branch networks they have minimal operating costs.
Banks want the largest possible “net-interest income;” that is, the widest gap between what they pay depositors and what they charge borrowers. With the Fed’s decision to keep interest rates where they have been, hopes for a higher net-interest income are disappearing. As The Wall Street Journal reported last week, “the decision by the Fed Thursday to stand pat — along with the fact that the overall tone emanating from the central bank was more dovish than expected — is forcing investors to rethink banking prospects.
“Namely, that it is now more likely that net-interest income and margins will remain flat, or possibly even decline further, in coming months. That will keep bank stocks under pressure as valuations had already been anticipating a more-favorable interest-rate environment.”
For financial services companies there are three interesting options for the dilemma they face.
First, start nonbank subsidiaries — and then collect the better margins or sell the nonbanks off to the public via stock offerings.
Second, if cheaper money is available elsewhere then borrow from them instead of the Fed. This would mean that interest rates for such things as mortgages and auto loans might remain stable or actually fall even if the Fed raises rates.the Fed raises rates.
Third, stop being banks. As examples, Goldman Sachs and Morgan Stanley only became bank holding companies in 2008, so why not the reverse? Some banks — looking at their margins — might want to become independent investment banks not regulated by the Fed. Or nonbanks. Traditional banks might sell off their branch systems and keep the divisions which could easily be used to form nonbanks. Such transitions are good opportunities to sell stock and raise share values.
Will traditional banks really consider such options?
A 2014 study by Accenture found that “younger bank customers are nearly twice as likely as older customers to consider switching to a branchless bank and to consider banking with major technology players if those companies offered banking services.”
“The survey also found that significant percentages of consumers — particularly younger ones — would be open to banking with technology players such as Google, Amazon and Apple if the companies offered such services.”
In the new world of nonbanks does anyone really believe that Google, Apple or Amazon would want to be regulated by the Fed if they offered mortgages and auto loans? Does anyone believe that traditional banks are immune from new forms of competition? These are questions which financial service companies now need to consider with greater urgency.