How Rising Interest Rates Are Impacting Banks and Savers

Table of Contents

• Introduction
• Federal Reserve Policy and Interest Rates
• Declining Bank Interest Rates
• Better Returns Outside of Traditional Banking
• Need for Banks to Adapt
• Conclusion and Summary

Introduction to Declining Bank Interest Rates

In recent years, interest rates offered by banks on savings and checking accounts have steadily declined. This has been driven by changes in Federal Reserve policy and fluctuations in the Fed Funds rate. As rates paid to customers have dropped, many savers have started looking elsewhere to earn better returns on their money.

This article will examine the factors behind the lowering deposit rates at banks. It will also discuss the impacts on consumers and how they can find better yields outside of traditional banking products. Finally, it will look at the need for banks to adapt and become more competitive to prevent further loss of deposits.

Overview of Declining Bank Interest Rates

Interest rates offered on common bank deposit accounts like savings and checking have been decreasing for many years now. This downward trend has left these accounts earning just a fraction of a percent annually. Meanwhile, rates available on other low-risk investments have become comparatively higher. This divergence means savers and depositors have an incentive to move their money out of traditional bank accounts. For banks, it threatens a key low-cost source of funds to lend out profitably. This article will explore the background behind these trends and the implications looking forward.

Federal Reserve Policy and Interest Rates

A major driver behind the changes to bank deposit rates has been the monetary policy of the Federal Reserve. Through its Federal Funds rate, the Fed influences broader interest rates and borrowing costs throughout the economy.

As the Fed has cut its policy rate to near zero since the Great Recession, yields on safe investments like bank accounts have fallen in tandem.

Fed Funds Rate Fluctuations

The Federal Funds rate is the interest rate banks charge each other for overnight borrowing. It is a key benchmark that impacts many other rates. In response to the housing crisis and recession, the Fed took unprecedented action by cutting the Fed Funds rate to 0-0.25% in late 2008. It remained at this record low level for seven years until 2015. Since then, there have been some increases, including a few hikes in 2018-2019 that brought the rate up to 2.25-2.5%. However, with the COVID-19 pandemic, the Fed again quickly slashed rates back down to near zero in March 2020.

Impact on Bank Interest Rates

As the Fed Funds rate goes up and down, interest rates on bank retail deposit accounts tend to follow suit. However, since the Great Recession, those rates have not kept pace. Even as the Fed Funds rate rose from 0% to over 2% by 2019, the average savings account rate barely topped 0.1%. Now with the rate falling again, savings yields have dropped back below 0.1%. This growing gap demonstrates how Fed policy has influenced the ongoing decline in interest paid by banks.

Declining Bank Interest Rates

While influenced by Fed actions, other factors have also driven down the rates on bank accounts. Deposit rates have lagged as banks deal with squeezed profits and shifting consumer behavior.

Savings accounts that once earned 5% now often pay 0.01% or less. Checking accounts earn even less, if they pay any interest at all. Savers have seen years of diminishing returns from traditional bank products.

Savings and Checking Accounts

The average interest rate on savings accounts has fallen from around 5% in 2007 to just 0.06% as of October 2022 according to FDIC data. Rates on interest checking accounts have dropped similarly over that period. As bank profits took a hit from the financial crisis and recession, they lowered deposit rates to protect margins. Growing industry concentration has also reduced the competitive pressure to offer better yields.

Loss of Traditional Revenue

Another factor in the rate declines is that low interest loans have cut into bank profits, shrinking a key revenue source. Mortgages and other consumer loans are a significant income generator when banks collect higher interest payments. But with low Fed policy rates keeping borrowing costs down, this interest income has decreased. For example, 30-year fixed mortgage rates averaged just 3.1% in 2020 versus 6.3% in 2007. To maintain profitability as traditional lending revenue has fallen, banks have reduced payouts to savers.

Better Returns Outside of Traditional Banking

While bank rates have dropped substantially, government securities and investment products are still offering relatively attractive yields.

Savers fed up with tiny bank interest have started moving funds to bonds, brokercage accounts, and other alternatives promising better returns.

Treasury Securities

Short-term U.S. Treasury bills and notes have emerged as an appealing option compared to bank accounts. While not risk-free, they provide competitive yields with the safety of government backing. For example, 1-year Treasury notes were yielding around 4.5% in late 2022. Compared to a typical savings account at just 0.06%, Treasury yields are 75 times higher.

Brokerage Accounts

Brokerage firms such as Charles Schwab and Fidelity have launched high-yield cash management accounts to attract investor deposits. These accounts offer up to 2% interest on cash balances - significantly better than bank rates. By keeping cash at a broker instead of a bank, consumers can earn extra yield while still having ready access to invest it whenever they want. The drawback is broker accounts may not have the same government-backed insurance as bank deposits.

Need for Banks to Adapt

To prevent losing more deposits to competing products, banks will likely need to start improving their customer rates again. This may require adapting strategies and accepting lower income for a time.

If banks want to keep customer funds flowing in, they need to rethink their outdated savings and checking account models.

More Competitive Interest Rates

The wide interest rate gap between bank accounts and alternatives like Treasury securities highlights the need for banks to increase competitiveness. With other safe options earning multiples more, they have room to raise rates. This will squeeze bank profit margins temporarily. But it may be necessary to satisfy customers and avoid accelerating outflows of deposits. Even incrementally higher rates can help banks stay relevant.

Prevent Loss of Deposits

Boosting deposit account rates - even if still below Treasury yields - can help banks avoid losing more funds. Every dollar that leaves bank deposits is potential lending capital lost as well. While the higher payouts will cut into income initially, retaining stable, low-cost deposit funding ensures banks have capital available to generate interest income through loans down the road.

FAQ

Q: How do changes in the Fed interest rate impact bank deposit rates?
A: As the Fed raises or lowers rates, banks generally adjust savings and checking account rates accordingly, to maintain profit margins between borrowing and lending costs.

Q: Where can savers earn higher interest rates than traditional bank accounts?
A: Options like Treasury securities, high-yield savings accounts, CDs, money market accounts, and some brokerage accounts can offer savers higher interest rates.

Q: Why are falling deposit rates problematic for banks?
A: Banks rely heavily on deposit interest as a revenue source. As rates fall, deposits become less profitable, threatening a traditional component of bank earnings.

Q: What can banks do to remain competitive amid rising rates?
A: Banks may need to offer more attractive deposit interest rates to customers to prevent outflows to alternative higher-yielding investments as rates rise.

Q: How does the health of bank deposit rates indicate economic outlook?
A: Declining bank deposit rates can signal concerns about economic growth, as banks anticipate weaker loan demand and try to preserve margins.

Q: Are Treasury securities a viable alternative to bank accounts?
A: For short-term savings goals, Treasury securities can offer a relatively low-risk way to earn higher yields than traditional bank deposit accounts.

Q: What are the risks of keeping cash in a brokerage account?
A: Unlike bank accounts, brokerage account cash balances are generally uninsured and carry some risk of broker insolvency, albeit low.

Q: How quickly do bank deposit rates adjust to Fed rate moves?
A: Deposit rate adjustments tend to lag behind Fed rate changes, as banks seek to maintain profit spreads.

Q: Where have bank customers been moving funds amid rising rates?
A: As yields have risen, over $100 billion has reportedly flowed from regional to large banks offering more competitive rates.

Q: What other factors impact bank deposit profitability?
A: Loan demand, credit losses, and capital requirements also determine how much revenue banks can generate from deposits.