The banking sector can be saidto be perhaps the most important financial intermediary in the economic set upof any nation due to the role that it plays in the provision of liquidity inmonitoring services and as information producers.
(Diamond & Dybvig 401). The banking sector acts as providers of essential financial services thatfacilitate the economicgrowth and development inmost countries. For example, the banking sector largely lends money for development of new businesses, purchase of homes, creditlending, and providing a safe place for storage of wealth by the society. Theimportance of the financial sector in the growth and development of a country’s overalleconomy can therefore never be underestimated especially given the sector’s domination of a nation’s economic development through themobilization of the general people’ savings and its ability to channel ittowards investment and economic growth and development, so that generally thenthe profitability of the banking sector will have direct effect on the nation’soverall economic growth and development. Given the risky and the volatilenature of the banking environment, banks are constantly exposing themselves torisks that could lead to financial losses and instability, or even a country’s economic collapse asevident from the global financial crisis of 2008 that impacted and continues toimpact the global economy, which started to some extent by the financial sector’staking of unreasonable risks. The performance of the banking sector willtherefore be affected by various macroeconomic variables ranging from highinflation, volatility in exchange rates,narrow export base, corruption, small foreignexchange reserve etc. The aim of this paper is thereforeto look at inflation and interest rates growth as the two factors that couldaffect the performance ofbanks, and in this particular instance look at their effects on the performance of Wells Fargo.Incorporated in 1929, Wells Fargo is a bank holding company operating as a diversified financial services company.
The company operates under threesegments; community banking, wealth and investment management, and wholesalebanking providing banking services that range from commercial, retail, and corporate banking through locations and offices, the internet, and various other channels of distribution. The company is also engaged through itssubsidiaries in other financialservices; mortgage banking,wholesale banking, equipment leasing, consumer finance, agricultural finance, securities brokerage, trustservices etc. WellsFargo offers its financialservices largely under three categories; small businesses, personal, andcommercial banking (Reuters). Wells Fargo is the world’s second largestbanking institution by market capitalization and the third largestin the USA by assets.
In 2016, the bank fell behind JP Morgan Chase by market capitalization following thescandal that saw the bank charged $185million and a further $5 million for creating more than two million fake products accounts in order to meet sales target, which saw the company’s shares fall more than 3% (Cheng). While relatively the company cannot besaid to be struggling as such, in their latest financial quarter report thecompany reported quarterly revenues of $21.93 billion which was below theanalysts’ projected revenues of $22.4 billion with the bank’s performancehighly impacted by the high legal costs it had to pay, with the legal costs increasingthe company’s efficiency ratio to a worse-than-expected 65.5%. Revenues fell2% compared to the samequarter last year, whilethe company’s shares represented a fall of 3%,with the litigation costof $1 billion contributing to the $1.3 billion loss in operating costs(Cheng).
Macroeconomic Indicators and Financial Performance Macroeconomicfactors are those factors that are pertinent to an economy that is broad at thenational or regional level and that affect a large population as opposed to selectfew individuals. These factors include gross domestic product (GDP), inflation,exchange rate, consumer sentiment, unemployment rate etc. According to variousliteratures and studies the business cycle has been shown to affect thefinancial performance of a bank (Kaufman 156). During times of financial boomfirms and households have been shownto commit a large part of theirincome flow to servicing debt, with preference being placed onleverage that follows a pro-cyclicalpattern. Everything at a constant, the bank’s income and thedemand for leverage tend to rise with the business cycle with Laker (41) studyof research conducted on the issueshowing that GDP growth and movements in the interestrates are the strongestvariables associated with strong bank income.
The most commonly usedmacroeconomic variables are inflation rate and the interest rate growth.Inflation Rate Inflation can be defined as the rise over a period of time ofthe general level of prices of goods and services. With each price levelincrease, the currency unit is only able to buy fewer goods and services. Consequently, therefore, inflation is areflection of the reduction in the powerof purchase per unit of money. The rate of inflation is the primary measuringvariable of price inflation, which is thepercentage change in a year ofthe general price index-usuallythe consumer price index-overa period of time.
The impacts of inflationon an economy can be either positive or negative, with the negative effect being; uncertainty over future inflationthat discourage investment and saving, shortage of goods through consumers’ hording out of their concern for future prices, increase in the opportunity cost of holding money. The positive impacts include; central banks have the opportunity toset and adjust real interest rates in order to mitigate against recession, and it encourages investment in non-monetary capital projects. Inflation is therefore a significant determinant of the performance of a bank, with high inflation usually connected with loan interest rates that are high and high income. According to Bashir (39) anticipated inflation canpositively affect a bank’s performance whileunanticipated inflation will have the opposite effect.
Anticipated inflation boosts a bank’s performance as it gives the bankan opportunity to adjusttheir interest rates whichresults in revenues that tend to increase faster than their costs. Bourke (70) also observed this positive relationship, observing thathigh inflation ratesled to higher loan rates which in turn lead to higher revenues for the bank. In the USA the Federal Reserve-the central bank-is responsible for evaluating changes in inflation by monitoring several different price indexes. To ensure the inflation data is accurate the Federal Reserve considersthe several price indexes instead of just one due to the fact that the different price indexes track different products and services, and are therefore calculated differently,which can send different indication about the inflation. The Federal Reserveputs an emphasis on the price inflation measure for personal consumptionexpenditures (PCE) which is reported by the Department of Commerce due to thefact that the PCE index is able to covera wide range of household spending unlike other indexes.
However, they also monitor other inflation measures such as consumer price index (CPI) and producer priceindex (PPI) which are reported by the Department of Labor. The rate of inflation in the USA is calculated over a period of time-usually monthly and annually. The past two years-2015-2016, saw some deflation and inflation. In 2015 the annual average inflationrate was 0.
73% which was largely due to a drop in the prices of oil and gas.However, the 2016 year saw the inflation rate surge to 2.07% due to increase in the consumer price index (McMahon); (seetable below) The current inflation rate for the year ending in November 2017 was 2.20% whichrepresented a risefrom the rate of 2.04% inOctober but a drop at the start of the year which was at 2.50% in January. Lately the inflation rate has been moving around its moving averagewhich indicates that it is relativelyflat. The inflation rate forthe next 12 months is forecasted to rise to around 2.
1% due to the gradualstrengthening of the economy. The economic growth will therefore lead to priceinflations in the housing, medical care and other services sectors which leadto total inflation. It is safe to saythat the economic indicator is a true reflection of the economic status of the country currently,seen from the resurgent economy coming after several years of slow economicgrowth under the Obama administration.
Therefore, growth in GDP is related to arise in the rate of inflation as spending increases, while increase in interest rates also affects inflation as it lowers itby scaring people to borrow more. The rate of inflation is a lagging economic indicator owing tothe fact that it takes a long period from thetime it is compiled andwhen it is released, and also it only gives a trend ofwhere the economy was and where it is going rather than where it is. The rise in the inflationrate for the year 2016 compared to the year 2015-which recorded an inflationrise of 1.3%-coincided with Wells Fargo’s growth in sales and income, with2016 recording a net income of$21.
9 billion compared to2015’s $22.8 billion. The company had to pay close to $1 billion in federal fines and legalcosts which affected its revenues. The company generated $88.3 billion inrevenues in 2016 which represented an increase of 3% from 2015. However, thegrowth and profitability is not entirely down to inflation rates going upespecially given the fact that inflation rates were relatively low, andinterest rates were also low due to slow economic growth and decline in oil prices (Wells Fargo , 7). Given that the company performed relatively well despite the slow economic growth and low interest rates Iwould recommend that they maintain their rates instead of raising them to avoidlosing customers. This is because the production capacity of the economy meanscustomers have more options to choosefrom and it wouldscare them if the bank passed the price of inflation to them.
Iwould say Wells Fargo’s stock is a safe bet for future long run. This isbecause the company creates shareholder value and offersthe ability to earnquality returns on capital. The company’s stock is also greatly undervalued whichgives investors looking for a long term investment a good opportunity toinvest. The viability of the company’s stock is seen from the ability of thecompany to increasingly grow yearly through all economic cycles, emerging fromthe financial crisis of 2008 as the most profitable of the big four banks inthe USA. Currently the company earns a return on investment of 10% which is a2% increase from 2008 (Trainer Para. 1).
Interest Rates Interest rate isanother macroeconomic variable that affects a bank’s performance. Low interestrates have been shown to help in the recovery of economies as seen from the lowrates maintained by the Federal Reserve after the global financial crisis inorder to encourage borrowing. Low interest rates enhance the balance sheets andperformance of banks by increasing capital gains, reducing non-performingloans, and supporting theprice of the bank’s assets. However, persistently low interest rates also affect the bank’s profitability as theylead to lower net interest margins (NIMs) (Claessens et al 1). In the USA the Federal Reserve is responsible forsetting the FederalFunds Rate which now stands at1.25-1.5% which represents a raise of 0.
25%, the third time the Fed is raisingthe rate this year. The interest rates in the country are determined by three major forces; the Federal Reserve that sets the fed funds rate which affectsshort term and variable interest rates; investor demand for U.S Treasury bonds and notes which impacts long term and fixedinterest rates; and the banking industry that offers loans and mortgages that have changing interest rates dependingon the business needs of the moment.
As seen from the figure above the Fed hiked the federal funds rate for the first time in nearly seven years since 2006 in 2015 by 25 basis percentage points to take it to 0.25-0.5% from, nearly a rate of zero. The rate was further increased in 2016 by another 0.
25 percentage basis points to take it to 0.5-0.75%. Currently the Fed rate stands at 1.25-1.
5% after the Fed’s latest hike. In their release of the new Fed rate in December this year the Fed announced a forecasted review of the rate three times for the year 2018, with a projected hike of 2.1% by the end of next year, with the strong economic growth and labor growth thought to be a factor, combined with an expected continued unemployment decrease over the next year. Interest rates are therefore lagging economicindicators as they are indicative of the economic position the country was and will be in future. Some of the economic indicators that affect interest rates are the inflation rates which give rise to high interest rates to curb the inflation and the decrease inunemployment rates which necessitates the increase in interest rates as it is assumedmore people will be spending in the market.
The increase in the Federal Funds Rate has a greatimpact on the company’s profitability,sales and growth. Due to the fact that Fed rates impact the company’s prime rates-the rates on the loans they give on their customers’ credit-an increase in the Fed rate would necessitate the increase in the bank’s prime rate as seen from the bank’s increaseof its rate to 3.5%almost immediately the Fed hiked the rates in 2015 (Cox Para. 21). Increase in the interest rates in the country boostedthe company’s netinterest income, which equatedto between $1billion and $2.4 billion in added revenue of the $47billion earned in the 2016 financial year.
Therefore,however small or large therise in interest rates would be, Wells Fargowould benefit(Maxfield Para. 2). Given therefore the positive growth of the economy and its projected growth over the coming year, I would recommend that the company increases its prime rates but in a balanced manner.
