Impact of interest rate cut on the banking sector

Published on September 23, 2024 by

On Wednesday, 18 September 2024, the Federal Reserve (Fed) cut the interest rate by 50bps for the first time in over four years. “The U.S. economy is in a good place…and we want to keep it there,” said Chairman of the Federal Reserve Board Jerome Powell at the press conference. He pointed to a strong labour market and lower inflation in supporting the decision to make this significant rate cut. He anticipates further cuts in the future,but emphasised they will be considered on a meeting-to-meeting basis.

Major US banks responded by reducing their prime rates to remain competitive. Analysts caution that while the rate cut is a positive step, its effects will be gradual, and loan growth may not fully offset lower net interest income for banks. Many analysts, investors and banks are still pricing in at least two additional rate cuts at the Fed’s next interest rate announcements in November and December.

Recent market data has supported the view that the Fed would have been better off cutting the rate in July, at the previous meeting of the policy-setting Federal Open Market Committee. Yet, this week’s rate cut comes with considerable analytical ambiguity about the endpoint for rates, surrounded by political uncertainty.

We have been in close touch with our clients, collaborating with them to prepare for such an announcement. Analysing the current macroeconomic environment, we think this rate cut will have major implications across the banking ecosystem.

We present a mood board of the likely impact across loan books and banking operations.

Wholesale and syndicated lending

The impact on wholesale lending markets and syndicated lending markets is significant, positioning them at unprecedented primary origination and subsequent secondary trading volumes at an unseasonal time. This would be challenging for firms across the markets to support operationally, while the markets are active – echoing volume hikes in syndicated lending at the start of the pandemic.

Leveraged finance

The long-awaited Fed rate cut should make it easier for non-investment-grade or non-rated issuers to tap the high-yield debt capital markets instead of filing for bankruptcy when their outstanding debt becomes due. As yields start falling, more and more companies are expected to capitalise on the favourable funding conditions and issue high-yield bonds that would help finance M&A activity.

With the Fed’s interest rate cut significantly reducing the cost of borrowing, there may be a surge in repricing and refinancing transactions in the leveraged loans market. Most of these deals would either have been pulled or never launched earlier due to the higher interest rate environment. In addition, the increasing gap between investor demand and leveraged loan supply since the Fed started increasing rates in 2022 would lead to demand for new loan deals until end-2024.

With interest rates declining, the leveraged lending loan market is expected to witness a further increase in the refinancing of existing loans, which may peak in 1H25. There would also be a decline in default rates on leveraged loans, as the rate cut environment is expected to continue until another 100-125bps is reduced. Hence, this rate cut would have a positive impact in terms of a subdued leveraged loan market.

Commercial real estate (CRE) lending

After a long time, the 50bps rate cut would result in more favourable borrowing conditions and drive CRE transaction volumes in the coming months. Given the large volume of CRE loans set to mature in the next two years (c.USD184bn, according to Trepp.com), we expect strong refinancing activity, as these loans would now be less costly. Apart from refinancing, this rate cut would also promote financing for construction projects as borrowing costs become cheaper. Developers may fast-track projects, especially those that were delayed or shelved due to high costs.

The affordable market segment may also get a boost, as the government could increase tax incentives so as to take advantage of market sentiment. Although the extent of the impact depends on government policy responses, this sector could see decent transaction movement.

In addition, a large chunk of commercial mortgage-backed security (CMBS) loans has been sent for special servicing in recent years (c.USD41bn as of December 2023) owing to higher interest rates. With the decline in interest rate, cashflow coverage would improve, and we expect quite a few loans to come out of special servicing. This would also result in lower loan loss reserves for banks, stimulating more money into the market and increasing deal flow.

The CRE sector struggled due to economic uncertainty, with recessionary concerns shifting investor sentiment due to higher interest rates. This rate cut would be critical for CRE while we wait for another round of cuts.

Consumer mortgage and retail lending

Residential real estate: With the rate decreasing, the US housing sector would attract a number of new first-time buyers who were waiting for a rate cut. The rate cut would also increase the volume of mortgage refinance. Considering these factors and the limited supply of inventory in the market, housing prices are expected to increase further. Supply has historically not kept pace with demand, as evidenced by the number of millennials still waiting to buy their first home.

Investment banking

M&A activity is expected to increase as the interest rate decreases. The effects of easing monetary policy are already being felt in Europe, with many banks cutting rates in 2Q, driving a 17% increase in M&A deal value over 1Q, according to PitchBook data.

Despite the aggressive start to rate cuts and the Fed’s direction, which gives deal makers more confidence, the rate is still high. Policymakers anticipate a policy rate of 3.4% by end-2025. A reduction in interest rates results in private equity (PE) firms pitching for more M&A aggressively. With the right exit strategies, PE firms can demand higher multiples for their portfolio companies, as buyers would be willing to pay higher multiples due to lower financing cost. The expected higher net profits would enable banks to opt for discretionary spending.

Investment-grade bond issuance markets are witnessing increased activity, with central banks starting to ease policy rates following the Fed’s rate cut. Both policy rate and bond yield differentials would drive capital flows, but through different channels depending on the type of investor flow. The decline in interest rate would lead to a surge in bond supply as quality investment-grade issuers start tapping the debt capital markets. FIG and sovereign issuers are expected to leverage the rate reductions as early birds, driven not only by lower borrowing costs but also the need to reduce dependence on banks to meet their capital needs via regulatory directives.

Around USD400bn of US non-financial corporate investment-grade bonds are set to mature every year from 2025 to 2028, according to Fitch Ratings, representing nearly a third of the USD5.7tn universe. Refinancing these maturing bonds would present significant opportunities for the investment-grade bond issuance market over the medium term.

Research teams of major banks would be busy assessing the impact of the rate cut on different sectors and bonds and would need to adjust their valuation models and stock/bond ratings. As the cost of funds decreases and the interest rate differential with emerging economies’ expands, some investments may find their way to countries such as India and China seeking better returns. This would require banks’ sell-side analysts to review their coverage of emerging markets.

Impact across the banking /lending value chain

While the loan origination market would trigger new lending business and amendments to current deals, political uncertainty in the US is also likely to drive markets to more volume than usual, leading to material stress on firms to keep up with market volatility.

The stress on loan operations in the lending market, from tier-one banks to sell-side firms, is due to its differentiation from other traditional products such as bonds, equity and derivative products that are settled on exchanges. Loans are less regulated and are settled on independent platforms or agreements, on average, at T+30 in the market vs bonds recently moving towards T+0. We expect a surge in new origination and secondary trading volumes, which would amplify the end-of-year stress on firms to fully understand their settlement exposure risk, and operational capability to keep up with volume.

In conclusion, the recent Fed rate cut is poised to trigger significant shifts across sectors in the banking industry, each of which is likely to experience increased activity as borrowing costs decrease. This opportunity also comes with operational considerations, particularly for firms managing the surge in loan origination and trading volumes. As market participants navigate these complexities, strategic adaptation will be crucial for capitalising on the changing economic landscape. We remain committed to supporting our clients through this dynamic environment with timely insights and tailored solutions.

How Acuity Knowledge Partners can help

With 22 years of credit experience and 1,200+ credit experts, our services cover the lending value chain from end to end, including origination, underwriting, credit monitoring and loan operations, across asset classes and portfolios (C&I, CRE, ABL, leveraged lending, consumer mortgage, retail, etc,). We have expertise across loan origination platforms and have developed our own proprietary automation tools across the credit analysis value chain, encompassing financial spreading, covenant monitoring, credit reviews and workflow management.