The providers of essential financial services that facilitate

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).

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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
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
RateInflation
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.o7%
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
RatesInterest
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 for setting 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.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
$47 billion 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.