Implications of Future Rate Changes for Cash Management Services
Fed more recently announced that it would hold interest rates steady for the foreseeable future
- Written by Lawrence Forman, Associate Director at Ernst & Young LLP, John Lothman, Senior Manager at Ernst & Young LLP, and Alan Zimmerman, Executive Director at Ernst & Young LLP
Over the past few decades, banks have earned fee income from corporate banking customers through the provision of cash management services. The Great Recession and the resulting sustained period of low interest rates suppressed net interest margins and the value of deposits gathered in conjunction with cash management services.
The gradual strengthening of the economy, corroborated by declining unemployment and increased wages, led the Federal Reserve to enact a series of interest rate hikes. These rate increases enhanced cash management relevancy and profitability due to the link between interest rates and cash management revenue.
Deviating from past few years, the Fed more recently announced that it would hold interest rates steady for the foreseeable future: “In light of global economic and financial developments and muted inflation pressures… the Committee will be patient” was described as the course of action in commentary from the Federal Open Market Committee statement from the March meeting.
With some doubts on the future strength of the economy emerging, Fed Chairman Jerome Powell made it clear that the case for raising rates has at least temporarily dissipated. This new stance carries significant implications for banks — particularly relative to generating and sustaining profits and growth from cash management services.
Each year, the Ernst & Young LLP (EY US) banking and capital markets team surveys cash management services to provide a benchmark of revenue growth and overall performance for this business line. This year’s survey recorded incremental changes in response to the rising interest rate environment. Now, with many observers anticipating few, if any, rate hikes in the next 12 to 18 months, how will banks adjust their strategies moving forward?
Linkage between Cash Management and the Economy
In 2015, the Fed gradually began raising interest rates, seven years into what would turn out to be a record-long bull market. That series of rate hikes helped drive additional growth in cash management services revenue, beyond the relatively meager growth realized after the 2008 crisis.
Although the bull market continues to run, some indicators of a slowing economy are coming to light. Cash management revenue growth is inextricably linked with economic growth. At its core, cash management is about managing payments, and more economic activity translates to more payments and more cash management revenue. Furthermore, higher interest rates increase the intrinsic time value of money — increasing the level of importance of strong cash management processes and strategies.
While cash management revenue rose incrementally after the financial crisis, we found it has plateaued in the past few years. Fears engendered by signs of a global slowdown and trade tensions have heightened economic uncertainty. Although numerous US economic indicators remain positive, many prominent economists are predicting a recession in the next few years due to the length of the expansionary period. Short of a full-blown recession, even a slowdown in our economic expansion is likely to inhibit payment growth, and negatively impact cash management revenue.
Given the economic outlook and the Fed’s response with a pause in interest rate hikes, now is an opportune time for banks to reassess their strategy. Forward-thinking banks have already started to reexamine how they approach their interest rate decisions that affect both their cash management clients and the bank’s net interest margin to prepare for future interest rate scenarios.
Pathway to Enhanced Profitability
While the clear majority of banks that participate in our survey agree their cash management departments are profitable in aggregate, there is room for improvement and market differentiation relative to peers. The Fed’s pause provides an opportunity to re-evaluate current strategies and map out potential scenarios to determine their likely impact when the interest rate environment begins to change again. Identifying the best path forward, in response to a changing environment, will set leading banks ahead of the pack in terms of future performance.
By Lawrence Forman, Associate Director at Ernst & Young LLP, John Lothman, Senior Manager at Ernst & Young LLP, and Alan Zimmerman, Executive Directorat Ernst & Young LLP
The views expressed by the presenters are not necessarily those of Ernst & Young LLP or other members of the global EY organization.
For more information, please reference Ernst and Young’s new report, “35th Annual Cash Management Services Survey.”
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