Lately I’ve been thinking about interest rates and compliance programs.
As you might have heard, the Federal Reserve has been raising interest rates for the last several years — from 0.25 percent at the end of 2015 (where they had been since 2009) to 2.25 percent today. The chairman of the Federal Reserve, Jerome Powell, has made clear that he expects to keep raising rates into 2019. They may well hit 3 percent or more by the end of next year.
That has implications for compliance officers and the programs you run, in subtle ways that not all compliance officers might appreciate. (Most compliance officers don’t study the mechanics of corporate finance in school, after all.) So let’s explore those implications today and what they might mean for you and your program going into the 2020s.
The compliance profession hasn’t seen a world of rising interest rates since 2006. Compliance professionals under 35 have never even experienced rising interest rates at all.
Interest rates affect what corporate finance professionals call the cost of capital. If your company borrows money, eventually it needs to pay back that money plus interest. The interest is the cost of the capital you’re borrowing.
Every time a company borrows money to do something — acquire a merger target; develop a new product; buy back shares of stock from Wall Street — the financial planning & analysis folks need to consider the cost of capital. They consider how the project will earn that borrowed money back, including the cost of capital. They consider whether other projects might produce a better return, and should get that money instead.
For example, a chemical company might consider borrowing $10 million at a 5 percent interest rate, to develop a new refinery. To make any financial sense at all, that refinery must generate at least $10.5 million in additional sales — the $10 million borrowed, plus $500,000 in interest. (Usually, the corporate finance gurus will want a project to generate much more.) If another project might generate $11 million, that’s a better investment; so the CFO will fund that one rather than our refinery.
Compliance officers do understand that idea, because we talk about the ROI of compliance investments all the time. We don’t, however, talk about exactly where that ROI number comes from, and what factors influence it. Well, interest rates influence it.
Here’s the thing, though: rising interest rates increase the cost of capital. So slowly but surely, Corporate America is entering an era where decisions about which investments to fund will become more competitive. The corporate finance gurus will want to see higher returns on everything to cover those higher costs of capital.
Including, say, investments in the compliance program.
Compliance Can’t Escape This
I know what you’re thinking: that you’ve never asked your CFO to borrow money for a compliance investment, and you never would. That’s true. Most compliance investments are too small to merit borrowing money, and no CFO would borrow money for operating expenses anyway. That makes about as much sense as taking out a loan to buy your weekly groceries.
Doesn’t matter. As interest rates rise and make the cost of borrowing more expensive, corporate finance departments will need to do more with existing capital generated from ongoing operations.
So our chemical company from above won’t borrow $10 million to open a new refinery. It might, however, take out a loan for $8 million, and cover the other $2 million with cash the company generates from ongoing sales. That’s 2 million fewer dollars available for other investments — and now your compliance project is competing with other internal investments for the smaller pile of cash.
That scenario can be avoided, if the company’s revenues are growing briskly. For example, if sales are so strong that available cash jumps from $5 million to $15 million, the chemical company won’t need to borrow any money for its refinery at all — and it still has enough money left over for that new automated due diligence software you’ve been eyeing.
On the other hand, if sales don’t grow briskly, then the company starts to feel pressure. It needs to be more disciplined in how it uses its cash and other assets (including people) to generate more growth.
That’s the whole macro-economic point of the Fed raising interest rates. If the Fed believes the economy is overheating, it raises rates to suck cheap capital out of the economy. Companies then need to be more disciplined about how they generate growth by internal operations.
So sometime soon, compliance officers might need both to justify the ROI of compliance more effectively, because you’ll have more competition for the cash; and to demonstrate a larger ROI overall, because the cost of capital is higher. That’s life in a tight-money world.
Most of us won’t hit that world tomorrow. Right now Fed chairman Powell is looking for that sweet spot where interest rates high enough to ward off inflation, but still low enough that companies grow briskly and do generate enough cash for investments.
We will, however, reach that world eventually. We always do.
Forward Into the Past
The compliance profession hasn’t seen a world of rising interest rates since 2006. Compliance professionals under 35 have never even experienced rising interest rates at all. So I wonder how well we’re going to do in that world (whenever it arrives) because it will bring challenges that many of us haven’t seen in a long time.
Look at this chart of interest rate history, below.
The compliance profession circa 2006 was fundamentally different than it is today. Cybersecurity, FCPA, cloud-based services, social media, privacy — those things barely even existed as compliance concerns in 2006. Today any one of them can be the job of a whole department.
A 38-year-old compliance program manager might run that department today, and run it well. But that 38-year-old was 24 the last time we were raising interest rates as we are now. Most likely, he or she was not running anything back then.
I understand that justifying resources for compliance programs has never been easy, and for many of the last 12 years the economy has been difficult, if not awful. Still, we’ve been making those arguments for compliance investment in a world of ultra-low interest rates. We’ve been making those arguments in a world where the economy only went upward (even in painfully slow increments), simply because things were so terrible in 2009 they couldn’t get any worse.
So those arguments went to CFOs and financial planning people working with one set of assumptions (low interest rates) that are giving way to another set (high interest rates). The whole atmosphere of corporate finance is changing — and compliance officers inhale that atmosphere every moment you’re on the job.
We often talk about the importance of compliance officers “knowing the business.” Take a deep breath as you read news articles about the Fed raising rates, Wall Street turning negative for the year, or President Trump declaring higher interest rates the biggest threat to his presidency.
That’s business today. Consider what it might mean for your compliance program and your career tomorrow.