The role that it plays in the provision of

The banking sector can be said
to be perhaps the most important financial intermediary in the economic set up
of any nation due to the role that it plays in the provision of liquidity in
monitoring services and as information producers. (Diamond & Dybvig 401). The banking sector acts as providers of essential financial services that
facilitate the economic
growth and development in
most countries. For example, the banking sector largely lends money for development of new businesses, purchase of homes, credit
lending, and providing a safe place for storage of wealth by the society. The
importance of the financial sector in the growth and development of a country’s overall
economy can therefore never be underestimated especially given the sector’s domination of a nation’s economic development through the
mobilization of the general people’ savings and its ability to channel it
towards investment and economic growth and development, so that generally then
the profitability of the banking sector will have direct effect on the nation’s
overall economic growth and development. Given the risky and the volatile
nature of the banking environment, banks are constantly exposing themselves to
risks that could lead to financial losses and instability, or even a country’s economic collapse as
evident from the global financial crisis of 2008 that impacted and continues to
impact the global economy, which started to some extent by the financial sector’s
taking of unreasonable risks. The performance of the banking sector will
therefore be affected by various macroeconomic variables ranging from high
inflation, volatility in exchange rates,
narrow export base, corruption, small foreign
exchange reserve etc. The aim of this paper is therefore
to look at inflation and interest rates growth as the two factors that could
affect the performance of
banks, and in this particular instance look at their effects on the performance of Wells Fargo.
Incorporated in 1929, Wells Fargo &
Company is a bank holding company operating as a diversified financial services company. The company operates under three
segments; community banking, wealth and investment management, and wholesale
banking providing banking services that range from commercial, retail, and corporate banking through locations and offices, the internet, and various other channels of distribution. The company is also engaged through its
subsidiaries in other financial
services; mortgage banking,
wholesale banking, equipment leasing, consumer finance, agricultural finance, securities brokerage, trust
services etc. Wells
Fargo offers its financial
services largely under three categories; small businesses, personal, and
commercial banking (Reuters). Wells Fargo is the world’s second largest
banking institution by market capitalization and the third largest
in the USA by assets. In 2016, the bank fell behind JP Morgan Chase by market capitalization following the
scandal that saw the bank charged $185
million and a further $5 million for creating more than two million fake products accounts in order to meet sales target, which saw the company’s shares fall more than 3% (Cheng). While relatively the company cannot be
said to be struggling as such, in their latest financial quarter report the
company reported quarterly revenues of $21.93 billion which was below the
analysts’ projected revenues of $22.4 billion with the bank’s performance
highly impacted by the high legal costs it had to pay, with the legal costs increasing
the company’s efficiency ratio to a worse-than-expected 65.5%. Revenues fell
2% compared to the same
quarter last year, while
the company’s shares represented a fall of 3%,
with the litigation cost
of $1 billion contributing to the $1.3 billion loss in operating costs
(Cheng). Macroeconomic Indicators and Financial Performance Macroeconomic
factors are those factors that are pertinent to an economy that is broad at the
national or regional level and that affect a large population as opposed to select
few individuals. These factors include gross domestic product (GDP), inflation,
exchange rate, consumer sentiment, unemployment rate etc. According to various
literatures and studies the business cycle has been shown to affect the
financial performance of a bank (Kaufman 156). During times of financial boom
firms and households have been shown
to commit a large part of their
income flow to servicing debt, with preference being placed on
leverage that follows a pro-cyclical
pattern. Everything at a constant, the bank’s income and the
demand for leverage tend to rise with the business cycle with Laker (41) study
of research conducted on the issue
showing that GDP growth and movements in the interest
rates are the strongest
variables associated with strong bank income. The most commonly used
macroeconomic variables are inflation rate and the interest rate growth.
Inflation Rate Inflation can be defined as the rise over a period of time of
the general level of prices of goods and services. With each price level
increase, the currency unit is only able to buy fewer goods and services. Consequently, therefore, inflation is a
reflection of the reduction in the power
of purchase per unit of money. The rate of inflation is the primary measuring
variable of price inflation, which is the
percentage change in a year of
the general price index-usually
the consumer price index-over
a period of time. The impacts of inflation
on an economy can be either positive or negative, with the negative effect being; uncertainty over future inflation
that discourage investment and saving, shortage of goods through consumers’ hording out of their concern for future prices, increase in the opportunity cost of holding money. The positive impacts include; central banks have the opportunity to
set and adjust real interest rates in order to mitigate against recession, and it encourages investment in non-monetary capital projects. Inflation is therefore a significant determinant of the performance of a bank, with high inflation usually connected with loan interest rates that are high and high income. According to Bashir (39) anticipated inflation can
positively affect a bank’s performance while
unanticipated inflation will have the opposite effect. Anticipated inflation boosts a bank’s performance as it gives the bank
an opportunity to adjust
their interest rates which
results in revenues that tend to increase faster than their costs. Bourke (70) also observed this positive relationship, observing that
high inflation rates
led to higher loan rates which in turn lead to higher revenues for the bank. In the USA the Federal Reserve-the central bank-is responsible for evaluating changes in inflation by monitoring several different price indexes. To ensure the inflation data is accurate the Federal Reserve considers
the several price indexes instead of just one due to the fact that the different price indexes track different products and services, and are therefore calculated differently,
which can send different indication about the inflation. The Federal Reserve
puts an emphasis on the price inflation measure for personal consumption
expenditures (PCE) which is reported by the Department of Commerce due to the
fact that the PCE index is able to cover
a wide range of household spending unlike other indexes. However, they also monitor other inflation measures such as consumer price index (CPI) and producer price
index (PPI) which are reported by the Department of Labor. The rate of inflation in the USA is calculated over a period of time-usually monthly and annually. The past two years-2015-2016, saw some deflation and inflation. In 2015 the annual average inflation
rate was 0.73% which was largely due to a drop in the prices of oil and gas.
However, the 2016 year saw the inflation rate surge to 2.07% due to increase in the consumer price index (McMahon); (see
table below)

 

 

The current inflation rate for the year ending in November 2017 was 2.20% which
represented a rise
from the rate of 2.04% in
October but a drop at the start of the year which was at 2.50% in January. Lately the inflation rate has been moving around its moving average
which indicates that it is relatively
flat. The inflation rate for
the next 12 months is forecasted to rise to around 2.1% due to the gradual
strengthening of the economy. The economic growth will therefore lead to price
inflations in the housing, medical care and other services sectors which lead
to total inflation. It is safe to say
that the economic indicator is a true reflection of the economic status of the country currently,
seen from the resurgent economy coming after several years of slow economic
growth under the Obama administration. Therefore, growth in GDP is related to a
rise in the rate of inflation as spending increases, while increase in interest rates also affects inflation as it lowers it
by scaring people to borrow more. The rate of inflation is a lagging economic indicator owing to
the fact that it takes a long period from the
time it is compiled and
when it is released, and also it only gives a trend of
where the economy was and where it is going rather than where it is. The rise in the inflation
rate for the year 2016 compared to the year 2015-which recorded an inflation
rise of 1.3%-coincided with Wells Fargo’s growth in sales and income, with
2016 recording a net income of
$21.9 billion compared to
2015’s $22.8 billion. The company had to pay close to $1 billion in federal fines and legal
costs which affected its revenues. The company generated $88.3 billion in
revenues in 2016 which represented an increase of 3% from 2015. However, the
growth and profitability is not entirely down to inflation rates going up
especially given the fact that inflation rates were relatively low, and
interest rates were also low due to slow economic growth and decline in oil prices (Wells Fargo &
Company Annual Report 2016, 7). Given that the company performed relatively well despite the slow economic growth and low interest rates I
would recommend that they maintain their rates instead of raising them to avoid
losing customers. This is because the production capacity of the economy means
customers have more options to choose
from and it would
scare them if the bank passed the price of inflation to them. I
would say Wells Fargo’s stock is a safe bet for future long run. This is
because the company creates shareholder value and offers
the ability to earn
quality returns on capital. The company’s stock is also greatly undervalued which
gives investors looking for a long term investment a good opportunity to
invest. The viability of the company’s stock is seen from the ability of the
company to increasingly grow yearly through all economic cycles, emerging from
the financial crisis of 2008 as the most profitable of the big four banks in
the USA. Currently the company earns a return on investment of 10% which is a
2% increase from 2008 (Trainer Para. 1). Interest Rates Interest rate is
another macroeconomic variable that affects a bank’s performance. Low interest
rates have been shown to help in the recovery of economies as seen from the low
rates maintained by the Federal Reserve after the global financial crisis in
order to encourage borrowing. Low interest rates enhance the balance sheets and
performance of banks by increasing capital gains, reducing non-performing
loans, and supporting the
price of the bank’s assets. However, persistently low interest rates also affect the bank’s profitability as they
lead to lower net interest margins (NIMs) (Claessens et al 1). In the USA the Federal Reserve is responsible forsetting the Federal
Funds Rate which now stands at
1.25-1.5% which represents a raise of 0.25%, the third time the Fed is raising
the rate this year. The interest rates in the country are determined by three major forces; the Federal Reserve that sets the fed funds rate which affects
short term and variable interest rates; investor demand for U.S Treasury bonds and notes which impacts long term and fixed
interest rates; and the banking industry that offers loans and mortgages that have changing interest rates depending
on the business needs of the moment. 

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As seen from the figure above the Fed hiked the federal funds rate for the first time in nearly seven years since 2006 in 2015 by 25 basis percentage points to take it to 0.25-0.5% from, nearly a rate of zero. The rate was further increased in 2016 by another 0.25 percentage basis points to take it to 0.5-0.75%. Currently the Fed rate stands at 1.25-1.5% after the Fed’s latest hike. In their release of the new Fed rate in December this year the Fed announced a forecasted review of the rate three times for the year 2018, with a projected hike of 2.1% by the end of next year, with the strong economic growth and labor growth thought to be a factor, combined with an expected continued unemployment decrease over the next year. Interest rates are therefore lagging economic
indicators as they are indicative of the economic position the country was and will be in future. Some of the economic indicators that affect interest rates are the inflation rates which give rise to high interest rates to curb the inflation and the decrease in
unemployment rates which necessitates the increase in interest rates as it is assumed
more people will be spending in the market. The increase in the Federal Funds Rate has a great
impact on the company’s profitability,
sales and growth. Due to the fact that Fed rates impact the company’s prime rates-the rates on the loans they give on their customers’ credit-an increase in the Fed rate would necessitate the increase in the bank’s prime rate as seen from the bank’s increase
of its rate to 3.5%
almost immediately the Fed hiked the rates in 2015 (Cox Para. 21). Increase in the interest rates in the country boosted
the company’s net
interest income, which equated
to between $1
billion and $2.4 billion in added revenue of the $47billion earned in the 2016 financial year. Therefore,
however small or large the
rise in interest rates would be, Wells Fargo
would benefit
(Maxfield Para. 2). Given therefore the positive growth of the economy and its projected growth over the coming year, I would recommend that the company increases its prime rates but in a balanced manner.