A significant proportion of U.S. non-bank financial institutions (NBFIs) would be adversely affected by an accelerated and higher-than-anticipated increase in US interest rates, says Fitch Ratings.

The impact on U.S. NBFIs of US interest rates reaching levels higher than current market consensus by 2020 is assessed in a special report published today. NBFI ratings incorporate Fitch's base case Fed Funds rate expectation of 2.5% by year-end 2018, though a recent special report from Fitch's economics group, "Unnatural Real Interest Rates," dated April 2017, discusses the likelihood of accelerated interest rates and a flattening yield curve by 2020.

Fitch's universe of NBFIs is wide ranging and includes finance and leasing companies, securities firms, investment managers, business development companies (BDCs) and financial market infrastructure companies. Some of these sectors could benefit from a higher-than-consensus rise in rates; however, most would be challenged by a range of effects, including deteriorating asset quality, margin pressures from higher funding costs and the flattening yield curve, and declines in mark-to-market valuations of assets. Still, a supportive economic environment would likely help to meaningfully mitigate the asset quality impact.

Profitability for varying NBFIs would be affected through a number of feed-through mechanisms. Rising debt service burdens for floating-rate borrowers would pressure asset quality for consumer finance companies and commercial lenders such as credit card lenders and BDCs, respectively. Rising funding costs would result for almost all NBFIs as well, while the flattening yield curve would add to margin pressures. Rising interest rates would also impact mark-to-market valuations on balance sheet assets for securities firms and BDCs and assets under management for investment managers.

Fitch sees mitigating factors to these challenges. The rising rate environment is expected to be accompanied by economic growth stabilizing above 2%, and improved macro conditions could moderate the effects of rising rates on consumer and commercial credit asset quality. NBFIs should also be less affected by the flattening yield curve than banks considering they generally maintain longer funding durations and shorter asset durations and try to match the maturities of some of their debt to their assets.

There will be some NBFI beneficiaries from accelerated rate rises even if the broad effects are negative. These would include some investment managers and financial market infrastructure firms that benefit from increased trading and market volatility.

Fitch does not expect rating changes would result from any temporary shifts in credit risk profiles due to unanticipated rate rises. However, should these changes be combined with other issuer-specific trends or expose broader risk management issues, they could factor into rating actions.

This analysis is part of a series of special reports related to Fitch's updated view that recent U.S. rate hikes could mark the beginning of a significant shift in the global interest rate environment. For detailed analysis of these views, see the following special reports listed in Related Research below.