19 July 2023 Revisiting interest rates, bank profits, and savings rates

Revisiting interest rates, bank profits, and savings rates​

What do you need to know this week?

In developing your commercial awareness, it is important to stay on top of market developments. That is why this week, we return to the nexus of issues at play related to:

• Interest rate hikes;
• The uptick in banking profits because of increase net interest margins; and
• The FCA’s scrutiny of the savings rates banks are offering savers.

Here are the updates:

Interest rates

(Primer: Interest rates determine the cost of credit. We know that central banks raise interest rates to slow inflation because inflation is caused by too much spending. By increasing the cost of credit for everyone, fewer businesses and individuals borrow money. Over time, this should decrease spending and bring down inflation.)

Inflation rates in the US have slowed dramatically to 3% in the month of June. This suggests — though by no means guarantees — that the Federal Reserve (the US central bank) will start unwinding its interest rate hikes over the next six to eighteen months.

Inflation in Europe and the UK remains much higher. That said, on Monday, new UK inflation data suggests that grocery price increases, which have contributed massively to inflation figures, have started to ease. And today, inflation figures fell to 7.9%, beating economists’ expectations.

While by no means is this conclusive, it could be that the inflation rate is slowing on this side of the Atlantic as well. But it is still far too early to conclude when — or even if — we will return to the low-interest rate environment the markets enjoyed from 2009 to 2021.

Banking profits

The extent of the profit banks make on lending depends on the difference between:

1. Their cost of credit — i.e., the amount they either:
   
   (i) pay to borrow money from another bank; or
   (ii) pay business and retail savers to deposit cash with them; and
   
   
2. the cost they charge borrowers to lend them this money — i.e., the borrower’s cost of credit.

In both cases, the cost of credit depends on the base interest rates.

Banks have benefitted from the increase in base rates because they have kept their cost of credit low while charging much higher lending costs to their borrowers. This difference is called the bank’s margin (“net interest margin”).

The large margins explains why certain US banks including JPMorgan, Citigroup, and Wells Fargo have together posted $49bn in interest margin profit. For context, this is 30% higher than this time last year.

UK savings rates

Because the lending divisions of banks fare better during high-interest rate environments, the FCA has asked the banks to explain why they have not passed on their fortunes to savers. Specifically, the FCA has commissioned a report and convened hearings to investigate the issue. Implicit is the threat of FCA intervention.

The banks have pushed back against the FCA, saying that interest rates they charge on mortgages and certain other kinds of loans do not directly correlate with the savings rates they offer deposit holders.

Coincidentally, as of this week, the UK’s largest banks have started offering higher savings rates for business and retail savers. Some commentators and banking industry defenders say this is independent of the FCA’s investigation…

Why is this important for your interviews?

These three interrelated developments raise important questions for banking clients. We addressed these in our forum discussion, as well as during TCLA’s first-ever “Commercial Awareness Office Hours”.

The most recent updates answer some questions while raising others. From an application and interviewing perspective, you may wish to consider further:

• How “fair” it might be for the FCA to scrutinise banks if their earnings figures across the rest of their business divisions have not dramatically changed (and why this might be the case)?
• What rights or powers does the FCA have to investigate and potentially intervene in the decisions of the banking sector?
• How the FCA’s investigation and potential intervention may be detrimental to the banking sector’s confidence in the UK market. In other words, is it a proportionate response for the FCA to get involved as they have?

How is this topic relevant to law firms?

The answers to these questions are areas where law firms can add value for their banking clients. You may therefore find it helpful to consider how exactly law firms might do this.

TCLA has created a new thread to discuss these developments here. All are welcome to join!