Coping with rising rates.

AuthorFoster, Jeremy

Financial institutions face a margin squeeze if interest rates start to rise as predicted. One defensive measure is a rewards-based checking product.

Many financial institutions could see their margins squeezed if rates rise soon. Fortunately, a surprisingly sellable solution can help.

In a rising rate environment, banks have often relied on products such as certificates of deposit (CDs) to ease the transition. However, CDs are only a short-term hedge against rapid rate increases, after which they promptly reprice. They can also be a tough sell for consumers who are reluctant to lock their money up for months or years, especially if they think interest rates are on the way up.

Rewards-based checking products offer a better solution. Their value for banks increases in a higher-rate environment, and they become more appealing to consumers as rates rise. Research has shown that rewards checking accounts can lead to longer-term, more profitable relationships with account holders. Rewards checking can also generate noninterest income and benefit banks in any interest rate environment.

The trouble with rising rates

Predictions about the future rate environment vary. However, the consensus is that there will be a long, slow increase. Both market expectations and comments from the Federal Reserve chairperson Janet Yellen suggest that the increase will likely be very gradual over the next few years.

Whenever rates do go up, financial institutions will see their interest costs rise, which will likely squeeze some institutions' margins. To manage that squeeze, banks have traditionally turned to promoting products such as CDs.

In a rising rate environment, CDs can lock customers in at lower rates for a period of time, so banks don't see their interest costs increase all at once.

Yet, over the long term, CDs aren't an ideal solution, and a long, slow increase in rates creates exactly the wrong environment for CDs.

Why? Eventually, CD terms expire, and consumers move to products paying the prevailing higher rate. CDs can also be a tough sell. Consumers, especially in a still-volatile economy, are wary of locking up their spare cash in a financial product for months or years.

When rates rise, consumers often don't want to settle for today's rate, when it's likely to be higher tomorrow. As a result, banks may overpay for CDs and gain minimal protection in exchange.

Rewards-based checking

Rewards-based checking solutions may provide a more attractive...

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