ECONOMY HEATS UP

Northwestern Financial Review, Mar 15-Mar 31, 2004 by Hilgert, Jackie

Rising interest rates coming, bankers at ABA conference say they're ready

In an industry where change is constant, some changes still come as news to bankers. That's likely the reason more than 500 bankers attending the American Bankers Association's Community Bankers Conference Feb. 22-25 in Palm Desert, Calif., eschewed the lush fairways to hear how the expected changes in interest rates would affect their businesses.

In 1993, the United States had one of the worst bond markets ever and "we're setting ourselves up for the same thing to happen this year," said economist Brian Wesbury. "The Federal Reserve is creating massive liquidity and this is building pressure for inflation and interest rates to rise," he added.

"Inflation is sneaking up on people and most are in denial about it."

Wesbury, chief economist at Griffin, Kubik, Stephens & Thompson, Inc., Chicago, boldly predicted interest rates would move long before the November presidential elections, perhaps as early as May or june. "Fed funds will start to rise and won't stop until the rate is about 4.5 percent," Wesbury said admitting he didn't know how long it would take the rate to get to that point. Wesbury predicted the prime rate would rise to 7 percent.

Although most economists have been saying the Fed won't raise rates until after the election, bankers have been acting like they expect an increase. In ABA's competitiveness survey, released at the convention, nearly all of the nation's bankers said they have taken steps to prepare their institutions for the long-awaited rise in rates. In fact, nearly 65 percent have extended cheaper, long-term deposits as much as possible, promoted adjustable-rate loans, and/or shortened their securities portfolios. A smaller percentage of bankers have match-funded larger loans as much as possible with wholesale funds.

A counter-offensive strategy more popular among nationally chartered banks, according to the survey, was to upgrade or replace asset/liability management software. Fewer state chartered institutions have taken that tack. Mark Slattery of LaSalle Bank, Chicago, said this is the time for bankers to establish where their greatest risks are in the yield curve. "A monthly review of balance sheets is not adequate at this time," Slattery said.

Bankers also have looked for ways to increase non-interest income and nearly 75 percent of them found solutions with mortgage fees and deposit account-related service charges. Banks report a 40 percent rise from a year ago in free checking offered by competitors. Ten percent of banks surveyed started to offer free checking in 2003; many listed free checking as a way to build a base for fee income.

ABA's survey indicates that fee-based overdraft services, although used more widely by large banks than by small banks, has been considerably more profitable for them than overdraft lines of credit or overdraft transfers from other deposit accounts.

Just as revenue from mortgage fees will begin to diminish as rates rise, revenue from deposit accountrelated fees may slip over time. Replacing non-interest income is something regulators are looking at all the time, said Jeff Plagge, president and CEO of First National Bank of Waverly, Iowa. "As we move more and more toward debit transactions and Check 21 - as float gets removed from the system - it will be interesting to watch how people control their accounts and see what happens to the revenue stream as a result."

The long-expected change in the interest rate environment is part of more dynamic change underway with the American economy. "The economy is structurally changing," Wesbury explained, pointing to technology as the driving force behind the change. Technology affects everything we do and the way that we do it and it will continue to grow, Wesbury predicted. The high tech sector now accounts for 5.9 percent of Gross Domestic Product and it will continue to grow to about 10 percent, he said.

Wesbury's optimism over the rise in the high tech sector comes in spite of steady decline in manufacturing jobs. "In 1970, one of every four jobs was in manufacturing; today that number is one in ten," he noted. We're making more goods in this country than we ever have, he added, but we're just doing it with fewer people. "A lot of people are in pain because of this, but the bottom line is, these changes are positive for our economy."

That approach doesn't sell well in an election year, however. Charlie Cook, a political analyst, told bankers that other than U.S. troops continuing to suffer casualties at the hands of Iraqi insurgents, only a continuation of our jobless recovery could keep President Bush from enjoying a second term. "Economists' predictions aren't that useful in an election year," Cook said. GDP growth doesn't matter, real job growth matters, he said. "It takes a lot longer to replace jobs lost to structural changes than it does to replace jobs lost to cyclical changes and if the numbers aren't there, we're headed for an election that's going to be real, real, real close."