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? ›

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.

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.

How do interest rates affect profit? ›

Investors and economists alike view lower interest rates as catalysts for growth—a benefit to personal and corporate borrowing. This, in turn, leads to greater profits and a robust economy.

How do interest rates hurt banks? ›

Besides loans, banks also invest in bonds and other debt securities, which lose value when interest rates rise. Banks may be forced to sell these at a loss if faced with sudden deposit withdrawals or other funding pressures.

How interest rates affect financial performance of commercial banks? ›

The results show that interest rate spread positively affects firm performance. One percentage increase in interest rate spread increases return on assets by 0.137%, return on equity by 1.37%, and earnings per share by 8.11%.

How interest rates change affect banks 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 banks' 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.

How to improve bank profitability? ›

Take These 5 Steps for Greater Profitability
  1. Define relationships.
  2. Identify top and bottom performers.
  3. Manage risk appropriately.
  4. Price based on the relationship.
  5. Incent based on profitability.

Who profits when interest rates are high? ›

With profit margins that actually expand as rates climb, entities like banks, insurance companies, brokerage firms, and money managers generally benefit from higher interest rates. Central bank monetary policies and the Fed's reserver ratio requirements also impact banking sector performance.

How do banks make a profit in regards to interest rates? ›

They make money from what they call the spread, or the difference between the interest rate they pay for deposits and the interest rate they receive on the loans they make. They earn interest on the securities they hold.

Do banks like high or low interest rates? ›

Meanwhile, for large banks like JPMorgan, higher rates generally mean they can exploit their funding advantages for longer. They enjoy the benefits of reaping higher interest for things like credit card loans and investments made during a time of elevated rates, while generally paying low rates for deposits.

Why are banks losing money? ›

There are still several sources of strain on the U.S. financial sector. Funding costs and declining income weakened profitability in the second quarter. Banks have lost deposits for the past five quarters, as more folks tap into their savings. Banks are still using the Federal Reserve's emergency lending programs.

What is interest rate risk in banking? ›

Interest rate risk is the potential that a change in overall interest rates will reduce the value of a bond or other fixed-rate investment: As interest rates rise bond prices fall, and vice versa. This means that the market price of existing bonds drops to offset the more attractive rates of new bond issues.

How to profit from rising interest rates? ›

8 money moves to make as interest rates remain high
  1. In a nutshell. ...
  2. Search for banks with the best savings accounts. ...
  3. Keep an eye on credit card interest. ...
  4. Refinance a mortgage (it's not too late) ...
  5. Invest in stocks. ...
  6. Consider Treasury Inflation-Protected Securities (TIPS) ...
  7. Buy short-term bonds instead of long-term bonds.
May 9, 2024

What are the disadvantages of increasing interest rates? ›

Higher interest rates tend to negatively affect earnings and stock prices (often with the exception of the financial sector). Changes in the interest rate tend to impact the stock market quickly but often have a lagged effect on other key economic sectors such as mortgages and auto loans.

What is bank profitability? ›

Bank profitability, an indicator of bank performance, is a reflection of how banks are run given the environment in which they operate. Healthy and sustainable profitability plays a vital role in maintaining stability in the banking sector (Garcia-Herrero et al., 2009).

How does a low interest rate affect banks? ›

As interest rates fall, the lower profits from deposits imply lower overall retained earnings. Banks being famously reluctant to raise new equity or cut payouts, their equity and loan supply end up falling in tandem.

What happens when banks have negative interest rates? ›

When interest rates are negative, lenders pay borrowers for holding debt. This means that someone gets paid interest for holding a loan, such as a mortgage or personal loan. As such, banks lose out while borrowers benefit. Savers, on the other hand, lose out.

How has the lower interest rates affected the banking industry? ›

Intuitively, a decline in the policy rate creates a disincentive to receive deposits, since some reserves would be kept at the central bank earning a negative rate. This decreases the fraction of banks that take deposits, allowing all banks to increase their loan interest rates.

How do banks make money when interest rates are low? ›

When rates are low, banks pay their depositors lower rates but loans are still lent out with a significant spread. Additionally, when rates are low, there is more incentive for companies and individuals to borrow, increasing the demand for loans.

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