Rising interest rates may be bad news for borrowers and savers
Author: Alex Konewko
The global consensus around interest rate rises is now a case of “when” and “by how much”, rather than “if” rates will rise. With rate-rises seemingly inevitable, how might higher interest rates impact both borrowers and savers?
Why are interest rates rising?
Since the start of 2022, financial markets have built in the prospects of a rising interest rate environment. This is a significant change from what has been over a decade of very-low interest rates. It is anticipated to lead to sustained increases to interest rates in the US and Europe in the near-term, with the aim of curtailing the dramatic increases in inflation that have been observed in recent months.
Whilst opinions differ as to how many and to what degree interest rate rises will be implemented during 2022, it is widely accepted that interest rates are expected to rise with substance this year in the US, as well as to some extent in the UK and Europe.
The prospects of rising interest rates for households usually focusses on two segments: depositors (or savers), and borrowers. Traditionally, as interest rates go up: savers earn more credit interest on their deposits; whilst borrowers pay more debit interest for their loans.
Historic Interest Rates
Before the Global Financial Crisis in 2008/09, interest rates in Western economies were at levels close to historic averages, in the range of 4.0-4.5%. Since the global financial crisis, interest rates were reduced dramatically by central banks across the world and have been effectively maintained at record low levels, even turning negative at times, with the objective of using ultra-low interest rates to help stimulate economic growth.
Savers were encouraged to spend their surplus deposits as an alternative to the prospects of earning very-low returns by continuing to hold them in savings accounts. Borrowers had their debt obligations reduced also as a result, meaning lower repayments and higher disposable income. All of which was designed to help rejuvenate the economy by encouraging people to spend more.
As the Covid-19 pandemic hit the global economy in early-2020, already low interest rates were further reduced, and a full wave of stimulus measures were also announced by governments and central banks to support economies amid the crisis. Many of the stimulus measures involved pumping liquidity into financial markets and the financial system.
For households, the average annual growth rate of savings balances in Europe also rose dramatically, partly driven by those who were fortunate enough to continue to work and earn during lockdowns, also unable to go out and spend freely. Despite a splurge of spending during the summer months of 2021 as restrictions were unwound globally, annual savings rates amongst households continued to show double-digit growth rates until the end of 2021.
As for borrowers, total gross borrowing growth also slowed in Europe. Many credit-worthy borrowers were simply unable to find a reason to borrow. In addition, many have been using surplus disposable income towards overpaying and reducing their debt levels, where fortunate enough to do so.
Rising Rate Prospects & Risk Appetite
The prospect of rising interest rates for savers will be a welcome psychological boost for many who have seen savings returns dwindle. As deposit rates and yields have been painfully low for savers, it has also incentivised some into a ‘hunt for yield’ and new investment strategies.
Investment opportunities have generally become more accessible for households, whereby traditional deposit savers may have decided to make investment decisions into other asset classes that they previously may not have taken. This has been partly enabled by the rapid growth of technology to support hassle-free, low-cost, investment platforms for investors. However, the prospect of returning to an era where cash-deposits earn a reasonable return of interest may feel appealing to some savers.
A Financial System Flooded with Liquidity
The low interest rate environment has also been painful for banks in respect of their earnings. Most household deposits remain within the custody of banks, who also provide much of the funding and lending needs for households, be it mortgages, personal loans, credit cards, or other financing.
The business model of a banks in terms of utilising its balance sheet in simple terms is to optimise the spread (the difference) they pay out to customers in credit interest for deposits, and the money they earn in debit interest from borrowers. For many mainstream banks, the deposit rates paid to customers are typically offset by the debit interest earned on lending activities, even after provisions for bad loans.
However, many banks have in effect been flooded with liquidity in more recent years. Already high levels of savings balances from households and non-financial corporates have increased further because of the market dynamics as highlighted. Despite interest rates being cut drastically by central banks, many savers have simply continued to save.
The additional stimulus measure from governments and central banks has continued to increase liquidity in the financial system because of the global pandemic, which has also compounded the excess liquidity for many banks. In summary, many banks have found themselves with far more funding than they needed.
The result of this has meant that banks have been collecting deposits from customers almost unwillingly, despite offering close-to-zero interest rates for many savings products. In turn, as banks have sought to grow lending balances with their customers, competition has intensified in many markets between banks, as they compete to find borrowers to lend their surplus deposits on to. For many banks, this has negatively impacted returns on equity and dividends for their shareholders.
Normal Market Rules May Not Apply
The prospect of rising interest rates should typically mean borrowers start to prepare themselves for paying more for their loans, particularly those outside of fixed rate borrowing periods. For savers, the prospects of being able to generate higher interest rate retrns on their savings balances would also normally be expected. However, this is very much the traditional view.
We are currently in a market where many banks will be keen to start passing through any interest rate rises to borrowers, promptly. By increasing rates on lending products, banks will increase the interest income earned and help their profitability. In contrast, banks currently have much lower motivation for passing on rising interest rates to savers.
Banks in general still proportionally have too many deposits. Even with rising interest rates, many banks will still be paying negative interest rates to hold funds with central banks as well as receiving negative returns on other high quality liquid assets they are required to hold for financial stability and regulatory purposes. In summary, the surplus deposits from savers will still be hurting many banks financially for some months to come. For the near term, banks will be very motivated to see increases passed through to borrowers, but to a much lesser extent for savers.
But That Isn’t Fair?
We should of course remind ourselves that banks are businesses. Their business model is to make a healthy spread between interest income income and interest expenses. A rising interest rate environment in the near term will still be well below the historical average interest rates observed through recent history in Europe and the US. Banks and financial markets will also be carefully considering whether a rising interest rate environment may be short-lived if inflation dynamics start to reverse quickly, or rate cuts are needed to help stave off a recession.
This of course may not be the case for all banks. There will be certain financial institutions that seek to take advantage of opportunities of such market dynamics. This may be of benefit to borrowers who are willing to shop around for better lending rates, as some banks seek to win new customers. Vice versa, for savers, there may be some banks willing to offer higher than standard market interest rates on savings products, with a similar objective of winning new clients and growing market share.
Such dynamics can and should lead to opportunities for more proactive savers and borrowers to take advantage of.
Alex Konewko is an Affiliated Consultant with ARQ Group specialising in risk, financial services, ESG, and sustainability. Mr Konewko is a former Executive Director and Chief Risk Officer of MeDirect Bank (Malta) Plc, as well as previously holding various Senior Risk Management roles with HSBC in the UK, with over 20-years international experience in banking.