Interest rates and their impact on financial services companies 

Federal interest rates remain a significant factor in the daily operations and long-term strategies of various financial service companies, as rising or declining interest rates can alter a company’s strategy and outlook. It can change the types of loans and amounts of money a company may potentially borrow, while also affecting things such as the valuation of securities currently held by the company, any future investment ventures and future cash flow forecasts.

At this point in 2024, interest rates remain very high, as the economy has been burdened with inflation since the COVID-19 pandemic, leading to numerous rate hikes in the past three years, with eleven of those coming between March 2022 and July 2023. On Sept. 18, 2024, the Fed reduced interest rates by 50 basis points, which represented a reduction for the first time since March 16, 2020. Even with this reduction, interest rates remain well above the average from the past fifteen years.

Impact on financial services

As mentioned above, there are various impacts that rising interest rates can have on a company. One of these impacts is the effect on the diversification of a company’s investment portfolio. In the case of investment companies, or any company that holds securities, diversifying your portfolio is a keyway to hedge against any potential losses in riskier investments. When hedging with investments of lower risk, higher interest rates can affect the decision making going into how an investor diversifies.

Looking at trends in the financial services industry, bonds and related low risk securities have become increasingly popular amongst all types of companies, from your typical investment fund to even broker-dealers. They are a way of hedging the risk of other higher risk investments, such as stocks, options, etc. Bonds are a good example of the variables involved in the decision making when a company builds or alters their portfolio. If you hold an existing bond and interest rates increase, the value of your existing bond will fall. If you are still in the market for buying bonds, increasing interest rates will provide a higher yield for newly issued bonds. The decrease in value of existing bonds held by a company may lead them down different avenues of hedging, i.e. looking to purchase newer bonds at a higher interest rate. While the outcome of rising rates may not be so negative for companies looking to get into bonds, companies that have established bond portfolios will see the value of them decrease. Fortunately, this will only be a paper loss, unless the company intended to sell the bond before maturity, in which case the loss will become realized. This is a win for bond buyers and possibly a loss for bond funds, which regularly buy and sell underlying holdings.

Another impact of high interest rates is that the cost of borrowing money will increase for all borrowers. This can pose to be troublesome as the higher rates will increase the total cost of borrowing, either causing the company to foot the extra cost, or avoid the debt overall. On the other hand, the opposite would be true for banks and lenders, as the higher interest rates will increase the interest income earned by the company, potentially boosting profit margins.

Example in practice

Along with the afore-mentioned impacts, companies that deal with mortgage related business, like mortgage lenders, mortgage advisors, and mortgage software providers, will feel the impacts of higher interest rates. While lenders stand to make more money on loans taken during times of high interest rates, during those times the demand for debt historically tends to decrease. When high rates spook potential homebuyers, they will not be seeking to take out a mortgage. This lack of demand for mortgage loans trickles down to those companies that provide mortgage related services, such as advisory and software services.

In the financial services industry, this exact situation is commonly seen in practice, where a company that specializes in mortgage related services experiences a decrease in revenues over the past few years and have specifically attributed it to the fact that demand is down due to the current state of interest rates.

Overall conclusion

While higher interest rates may sound detrimental to any one of us, it has the ability to both help and hurt members of the financial services industry. Lenders, bond buyers, etc., stand to benefit the most from higher rates, as lenders will make more off of interest income and bond buyers will have the opportunity to purchase high yield bonds, while, borrowers, bond funds, etc. will be hurt by higher rates as the cost of borrowing will increase, amongst other factors.

When looking for solutions and guidance to the challenges facing the financial services industry, Baker Tilly’s Financial Services team has the experience and industry expertise to help.