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Macroeconomic
Factors Affecting the Banking Industry: A Case Study of Wells Fargo

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.

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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.o7%
due to increase in the consumer price index (McMahon); (see table below)

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