This week brought exciting news for the financial world. Janet Yellen, the fledging US Federal Reserve Chair, softened her stance once again on the quantitative easing process that has been going on for more than five years. Yellen pointed to the unemployment rate hovering at 5.5% and GDP growth stabilizing around their 2% target as the decision criterion.1 Now that the Federal Reserve’s two directives have been met, low unemployment and stable growth, the FOMC wants to stop forcing low interest rates with their bond-buying programs. This will have a huge impact on the banking sector in the United States. More specifically, we are going to look at what changes the banks will have to make on their balance sheet and any capital structure changes that might optimize shareholder wealth.
First of all, we know that banks are able to borrow at extremely low rates right now. As the risk-free interest rate rises the banks will also have to raise the coupon payments on new loans given out. This means that fewer projects will be accepted, and fewer loans will be given out. Also, in these times of low interest rates, banks have moved a lot of their loans into long-term obligations, because there is so little profit in the short term. As the risk-free rate rises and the economy moves towards a more normal interest rate curve, we expect banks to shift their balance sheet away from long-term debt and more towards short-term debt.
As far the firm’s capital structure is involved, we know a few things for sure and we can make educated guesses about more. A firm has maximized shareholder wealth when the weighted average cost of capital (WACC) is the smallest. Within the WACC we have the cost of equity and the cost of debt. The formula for the cost of equity is provided below, and we clearly see that if the Federal Reserve allows the risk-free rate to rise, equity will become more expensive for the firm. We believe this coupled with what we mentioned earlier namely, a change in bank’s balance sheet towards short-term loans will cause these firms to shift their capital structure more towards debt financing.
The last thing we want to look at is what banks have been doing in the exchange rate futures market and how it will change in the near future. Below is a sensitivity analysis done by Vincent Papa, PhD, CFA on the effect of interest rate changes on Barclays’ profits (in millions) in 2014.
What we see is that Barclays has been betting against rising interest rates. This makes sense because the Federal Reserve, in the midst of a financial crisis under Ben Bernanke’s watch, held fast to their promise of continued low interest rates. Now that Yellen feels we are out of the crisis, it’s clear that Barclays will have to change their positions on interest rate forwards and futures, or face significant losses.
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