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How Federal Debt May Impact Banking

BY CHRIS NICHOLS

finances, lowers average
The Federal debt is already impacting banking. Cyclical
wages, and increases the cost
economic changes are driven by business cycles. These changes may of borrowing money. Further,
occur swiftly, such as interest rate changes, inflation changes, or rising debt increases the
unemployment rate changes. Cyclical changes and their impact on the chances of fiscal crisis,
economy dominate the news and the attention of corporate decreases confidence in risk-
boardrooms because they are immediate and need to be addressed in taking, and, most importantly
real-time. for banks, higher debt increases

Secular changes occur over many business cycles, tend to be slow- the volatility of asset prices,
moving, and are more difficult to manage with business strategy. and personal and business cash
Because secular changes occur over decades, many management flow. As interest rates remain
teams miss the telltale signs of significant secular disruptions—think of higher, and the federal
a frog boiling slowly in a pot, not appreciating the changes in the water government is constrained in
temperature over a longer period. However, because bank capital has smoothing out business cycles,
an average expected life of 15 to 20 years, bank managers must gauge recessions become more
and react to secular changes that will impact their business model. severe and last longer.
Chris Nichols is Director of
We believe that one of the most significant and disruptive secular Bankers may not see the
changes in the banking industry in the next ten to 20 years will be the impact of the growing federal Capital Markets at SouthState
growing size of federal debt as a percentage of GDP. Bank, an ACB Associate Member.
debt burden on their business He can be reached at
Why The Growing Federal Debt Matters model year to year, but over cnichols@correspondent.
While there is some debate in academic circles if higher federal deficits longer periods, these changes southstatebank.com
lead to long-term changes in a developed economy (such as higher are poised to alter the way
interest rates or higher inflation), most economists believe that higher community banks do business,
deficits cause interest rates to rise, and a currency to appreciate. The manage risk, and target clients.

relationship between federal deficits and interest rates may depend Federal Debt – Impact Banking
on many complex factors, such as: whether tax rate changes, money The path of the federal debt is already changing economic and public
supply changes, government spending changes, or political and dynamics. With time, these changes will only amplify. An aging
economic stability worldwide accompany the deficits. However, the population, higher federal debt as a percentage of GDP, and higher
common thinking is that increasing federal government debt leads to interest rates will change the way community banks view risk, manage
higher interest rates over longer periods.
relationships, use technology, and generate revenue. We think that
Furthermore, high federal government debt does not just lead to community bankers should consider the following four business model
higher interest rates but also poses economic, national security, and changes because of higher national debt:

social challenges. What is most troubling is that the growth in the
Less risk-taking and a smaller pool of entrepreneurs will decrease the
federal debt is not the result of one administration or one set of policy
demand for small business loans. While the US is, and will remain, the
decisions, but rather, a reflection of our political system (politicians
center of innovation and risk-taking, the economy will transition to
that focus on reduced government spending are less electable –
fewer small businesses and more larger enterprises. Community
regardless of the party), and the aging demographics in the country is
banks’ focus on business banking must adapt to offer more
shifting policy to higher government spending and a lower tax base.
sophisticated products to larger business clients.
These changes associated with higher government budgetary spending
will have direct and consequential effects on the banking industry. • As interest rates rise and remain higher, the value of deposits will
grow. Community banks must deliver best-of-class treasury
The Nation’s Fiscal Health
Historically, congress and various administrations have not made the management products to capture this valuable banking product.

difficult budgetary and policy decisions to reduce the federal deficit or • Risk management will become even more important because the
curtail the growth of the federal debt as a percentage of GDP. higher absolute value of interest rates causes more asset price

By 2028, debt as a percentage of GDP will reach a historical high of variability. Proportional interest rate changes between 10% and
106% and will reach 200% by 2050. Unlike previous spikes in debt 15% (a 50-percentage point increase in absolute level) result in
levels, the projected debt increases are being driven by financing gaps more collateral devaluation than an equal 50 percentage point
in Medicare and Social Security, and the rapid aging of the US increase from 4% to 6%.

population drives demand for both. •
As risk management becomes more prominent, technology and
Why Bankers Should Care data mining become an indispensable tool. Human-driven risk
As debt is projected to grow twice as fast as the US economy by the management will be aided by more upfront risk assessment (AI
Government Accountability Office, it seems unlikely that policy or underwriting, risk-adjusted return on capital (RAROC)
budgetary changes will markedly alter this expected trajectory. All measurements, and other predictive analytics) and technology-
else equal, growing debt increases interest rates, dampens personal intensive ongoing risk monitoring.
A COMMUNITY BANKER | 22 | Spring 2024
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