How Interest Rate Changes Affect the Profitability of Banking (2024)

When interest rates rise, profitability in the banking sector increases. This is in part because higher interest rates are normally a sign of a booming economy. But profits rise mostly because the banks can earn a higher yield on every dollar they invest.

Banks make money by accepting cash deposits from their customers in return for interest payments and then investing that money elsewhere. The bank's profit is the difference between the interest they pay their depositors and the yield they make through investing.

Higher interest rates increase the yield on their investments. Interest rates can go too high. If they reach a level that makes businesses and consumers hesitate to borrow, the lending side of banking starts to suffer.

Key Takeaways

  • Interest rates and bank profitability are connected, with banks benefiting from higher interest rates.
  • When interest rates are higher, banks make more money by taking advantage of the greater spread between the interest they pay to their customers and the profits they earn by investing.
  • A bank can earn a full percentage point more than it pays in interest simply by lending out the money at short-term interest rates.
  • Moreover, higher interest rates tend to reflect a healthy economy. Demand for loans to businesses and consumers should be high, with the bank making better returns on those loans.
  • There's the risk that interest rates will go too high, discouraging borrowers.

How Low Interest Rates Affect Banks

The Federal Reserve reduces interest rates in order to encourage businesses and consumers to borrow more money, adding fuel to the economy. The banks will benefit by the rising demand for loans. But the profit from each loan will be lower, as will the amount the bank makes by investing in short-term debt securities.

How the Banking Sector Makes a Profit

The banking industry encompasses not only corner banks but investment banks, insurance companies, and brokerages. All have massive cash holdings. They hold onto a small portion of that cash to ensure liquidity.

The rest is invested. Some of it is invested in loans to businesses and consumers. Much of it is invested in short-term Treasury securities. This is the wave of cash that originates with the U.S. Treasury and flows constantly through the banking system. Even the very low interest rates that short-term Treasury notes yield are greater than the interest the banks pay to their customers.

It's similar to the way that an increase in oil prices benefits oil drillers. They make more money for the same expenditure of resources.

Example of Interest Rate Impact on Bank Earnings

Consider a bank that has $1 billion on deposit. The bank pays its customers an annual percentage rate of 1% interest, but the bank earns 2% on that cash by investing it in short-term notes.

The bank is earning $20 million on its customers' accounts but returning only $10 million to its customers.

If the central bank then raises rates by 1%, the federal funds rate will rise from 2% to 3%. The bank will then be yielding $30 million on customer accounts. The payout to customers will still be $10 million.

The bank may be forced to raise the interest rates it pays on deposits if higher interest rates persist. But the vast majority of its customers won't go in search of a better return for their savings.

This is a powerful effect. Whenever economic data or comments from central bank officials hint at rate hikes, bank stocks rally first.

When interest rates rise, so does the spread between long-term and short-term rates. This is a boon to the banks since they borrow on a short-term basis and lend on a long-term basis.

Another Way Interest-Rate Hikes Help

Interest rate increases tend to occur when economic growth is strong. Businesses are expanding, and consumers are spending. That means a greater demand for loans.

As interest rates rise, profitability on loans increases, as there is a greater spread between the federal funds rate that the bank earns on its short-term loans and the interest rate that it pays to its customers.

In fact, long-term rates tend to rise faster than short-term rates. This has been true for every rate hike since the Federal Reserve was established early in the 20thcentury. It is a reflection of the strong underlying conditions and inflationary pressures that tend to prompt the Federal Reserve to increase the interest rates it charges.

It's also an optimal confluence of events for banks, as they borrow on a short-term basis and lend on a long-term basis.

Note that if interest rates rise too high, it can start to hurt bank profits as demand from borrowers for new loans suffers and refinancings decline.

Are Higher Interest Rates Good for Stocks?

Generally, higher interest rates are bad for most stocks. A big exception is bank stocks, which thrive when rates rise. For everybody else, it's a delicate balancing act. Interest rates rise because the economy is booming. But increasing interest rates make businesses and consumers more cautious about borrowing money.

This is why the Federal Reserve acts as it does. It's raising or lowering the interest rates it charges to the banks in order to cool the economy or rev it up.

Are Higher Interest Rates Good for Bonds?

When interest rates increase, new bonds that are issued now have to carry a higher rate of return in order to be attractive to buyers.

However, the owners of older bonds are stuck with their lower rates of return. On the secondary market where bonds are resold, their value will decrease to compensate for the lower return. The investor who holds bonds in an investment portfolio doesn't lose money but does lose the opportunity to invest in higher-yield bonds.

Are Higher Interest Rates Good for the U.S. Dollar?

Higher interest rates are good for the U.S. dollar. When the Federal Reserve tweaks its short-term interest rates, the change ripples through all other types of loans, including the loans that are represented by U.S. Treasury bonds and, indeed, all other dollar-denominated investments.

When U.S. rates are high in comparison with those of other nations, money pours out of foreign investments and into U.S. investments. That tends to make the U.S. dollar rise in value against other currencies.

How Interest Rate Changes Affect the Profitability of Banking (1)

The Bottom Line

A rise in interest rates automatically boosts a bank's earnings. It increases the amount of money that the bank earns by lending out its cash on hand at short-term interest rates. At the same time, the bank's costs of doing business are unaffected. Their customers are unlikely to pull their cash out of their savings accounts in order to chase a slightly higher-yielding savings account. Thus, the spread widens between the interest the bank pays its customers and the interest it earns by lending it out.

How Interest Rate Changes Affect the Profitability of Banking (2024)

FAQs

How Interest Rate Changes Affect the Profitability of Banking? ›

First, an increase in market rates raises the amount of income a bank can earn on new assets it acquires. If a bank were 100-percent invested in overnight loans and securities, for ex- ample, its average revenues would change every day to reflect current market interest rates.

How interest rates affect bank profitability? ›

Key Takeaways. Interest rates and bank profitability are connected, with banks benefiting from higher interest rates. When interest rates are higher, banks make more money by taking advantage of the greater spread between the interest they pay to their customers and the profits they earn by investing.

What affects the profitability of a bank? ›

Their results determined that bank size, operating efficiency, leverage ratio, and inflation rate are the most critical determinants affecting bank profitability.

How does interest rate risk affect banks? ›

This risk is a normal part of banking and can be an important source of profitability and shareholder value; however, excessive interest rate risk can threaten banks' earnings, capital, liquidity, and solvency.

How interest rates affect financial performance of commercial banks? ›

The study concluded that interest rates variation, credit risk and inflation have an inverse relationship with Financial Performance of Commercial banks while GDP growth rate has a direct relationship with the Financial Performance of Commercial Banks in Kenya.

Do banks profit more when interest rates rise? ›

Rising interest rates can influence bank profitability positively (by increasing payments from those with floating-rate debt) or negatively (by forcing banks to offer higher returns to their depositors).

How do low and negative interest rates affect banks profitability? ›

As interest rates rise, a bank's ability to generate profits from the net interest margin between loans and applications increases and, as interest rates decrease, the need for banks to generate profits from non-interest income rises.

Why do banks fail when interest rates rise? ›

When commercial banks borrow—from depositors and other sources—over the short term and lend for long periods, it creates the risk that rising interest rates will reduce the value of their long-term assets.

What drives bank profitability? ›

Bank profitability is not only affected by bank-specific determinants, developments in relevant industries can also influence bank profitability. The empirical literature focusses on three determinants: banking sector concentration, banking sector development, and stock market development.

What are the 3 main factors that affect interest rates? ›

How are interest rates determined? Market conditions and the risks associated with lending largely influence interest rates. Factors such as inflation, economic growth, and availability of funds also play a role in determining interest rates.

Why are high interest rates affecting banks? ›

Higher interest rates have boosted banks' net interest income—resulting in higher net interest margins (NIMs) and enhanced profitability. Lenders have benefited from a widening of the spread between the interest they pay to depositors, and the income they reap on lending.

Who makes money when interest rates rise? ›

Banks make money from the interest they charge on loans. As interest rates rise, banks can often charge a higher interest rate on loans and credit cards compared with the rates they have to pay savings and other interest bearing accounts.

How negative interest rates affect banks and economy? ›

In a negative interest rate environment, an entire economic zone can be impacted because the nominal interest rate dips below zero. As such, storing cash incurs a fee rather than earning interest, which means that consumers and banks have to pay interest in order to deposit money into an account.

How do you profit from rising interest rates? ›

Some potential suggestions for bond investors in a rising interest rate and rising inflation environment include:
  1. Invest in shorter-duration bond mutual funds and ETFs. ...
  2. Ladder the maturities of individual bonds. ...
  3. Consider investing in inflation-protected Treasuries or TIPs.
Mar 7, 2024

How do banks earn profit? ›

They earn interest on the securities they hold. They earn fees for customer services, such as checking accounts, financial counseling, loan servicing and the sales of other financial products (e.g., insurance and mutual funds).

What are the financial impacts of interest rates? ›

Higher interest rates can make borrowing money more expensive for consumers and businesses, while also potentially making it harder to get approved for loans. On the positive side, higher interest rates can benefit savers as banks increase yields to attract more deposits.

Who profits when interest rates are high? ›

The financial sector generally experiences increased profitability during periods of high-interest rates. This is primarily because banks and financial institutions earn more from the spread between the interest they pay on deposits and the interest they charge on loans.

How do interest rates affect corporate profits? ›

A higher interest rate environment can present challenges for the economy, which may slow business activity. This could potentially result in lower revenues and earnings for a corporation, which could be reflected in a lower stock price.

What happens to money supply when interest rates rise? ›

Higher interest rates translate to a lower supply of money in the economy. Since the supply of money depletes, it raises borrowing costs, which makes it more expensive for consumers to hold debt.

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