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)
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