The banking sector'sprofitabilityincreases with interest rate hikes. Institutions in the banking sector, such as retail banks, commercial banks, investment banks, insurance companies, and brokerages have massive cash holdings due to customer balances and business activities.
Increases in theinterest ratedirectly increase the yield on this cash, and the proceeds go directly to earnings. An analogous situation is when the price of oil rises for oil drillers. The benefit of higher interest rates is most notable for brokerages, commercial banks, and regional banks.
How the Banking Sector Makes a Profit
These companies hold their customers'cashin accounts that pay out set interest rates below short-term rates. They profit off ofthe marginal difference between theyieldthey generate with this cash invested inshort-term notesand the interest they pay out to customers. When rates rise, this spread increases, with extra income going straight to earnings.
For example, a brokerage has $1 billion in customer accounts. This money earns 1% interest for customers, but the bank earns 2% on this money by investing it in short-term notes. Therefore, the bank is yielding $20 million on its customers' accounts but paying back only $10 million to customers.
If the central bank brings up rates by 1%, and thefederal fundsrate rises from 2% to 3%, the bank will be yielding $30 million on customer accounts. Of course, the payout to customers will still be $10 million. This is a powerful effect. Whenever economic data or comments from central bank officials hint at rate hikes, these types of stocks begin to rally first.
When interest rates rise, so does the spread between long-term and short-term rates, helping banks since they borrow on a short-term basis and lend on a long-term basis.
Another Way Interest-Rate Hikes Help
Another indirect way in which interest rate hikes increase profitability for the banking sector isthe hikes tend to occur in environments in whicheconomic growthis strong, and bond yields are rising. In these conditions, consumer and business demands for loans spike, which also augmentsearningsfor banks.
As interest rates rise, profitability on loans also increases, as there is a greaterspreadbetween the federal funds rate and the rate the bank charges its customers.The spread between long-term and short-term rates also expands during interest rate hikes because long-term rates tend to rise faster than short-term rates. This has been true for every rate hike since theFederal Reservewas established early in the 20thcentury.1
It reflects the strong underlying conditions and inflationary pressures that tend to prompt an increase in interest rates. This is an optimalconfluenceof events for banks, as they borrow on a short-term basis and lend on a long-term basis.
Important Note: that if interest rates rise too high, it can start to hurt bank profits as demand from borrowers for new loans suffers and refinancing drops.
Habeeb Mahmood
FAQs
Lower interest rates can decrease loan-loss provisions by reducing the cost of servicing debt and lowering default probabilities. Banks can also respond endogenously by increasing their non-interest income (for example, fee income) and reducing their costs of operating.
How do interest rate changes affect the profitability of banking? ›
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.
How would changing interest rates affect a bank's profitability Why would sensitivity analysis be important for a bank to perform? ›
This in turn changes the underlying value of a bank's assets, liabilities and off-balance sheet items and hence its economic value. Changes in interest rates also affect a bank's earnings by altering interest rate-sensitive income and expenses, affecting its net interest income (NII).
How can a change in interest rates affect the profitability of financial institutions quizlet? ›
A change in interest rates affects the cost of acquiring funds for financial institution as well as changes the income on assets such as loans, both of which affect profits.
How interest rate spread affects profitability 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%. Keywords: Interest rate spread, ROA, ROE, EPS & Commercial banks.
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 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.
Do changes in interest rates affect the profitability of the insurance sector? ›
Rising interest rates decrease the value of existing, lower-earning bonds in life insurers' portfolios. Long-term bonds and other interest-rate-sensitive investments are affected more than shorter-term investments, and life insurers tend to hold long-term bonds.
How do changes in interest rates affect the money supply? ›
Increasing interest rates doesn't increase a nation's money supply because the two have an inverse relationship. Higher interest rates translate to a lower supply of money in the economy. The supply of money depletes so it raises borrowing costs and this makes it more expensive for consumers to hold debt.
How interest rate risk affects financial institutions? ›
Bank profits are exposed to interest rates movements. Some banks issue interest bearing deposits so that their profits shrink when rates go up as they have to increase the compensation of deposi- tors. Other banks tend to lend at variable interest rate so that their profits go up when the short rate increases.
1.1.1 Interest Rates Background
High interest rates will lead to increased commercial banks interest income but also lead to low demand for the loans and hence crowding out the increased interest income.
What is profitability in banking? ›
It is defined as the ratio between a bank's earnings before tax and total assets. It is an indicator of how efficiently a bank uses its assets to generate earnings before contractual obligations must be paid. The higher the ratio the more efficient the bank at utilising assets to generate earnings.
How do Fed interest rates affect banks? ›
After the central bank raises its rate, financial institutions tend to pay more interest on high-yield savings accounts to stay competitive and attract deposits. Conversely, after the Fed lowers its rate, banks tend to lower their deposit account rates.
How interest rates affect financial performance of commercial banks? ›
The study found that a weak positive relationship between lending rates and performance of commercial banks. Since interest rates accounted for only 14.4% of the revenue in commercial banks, the study recommended income source diversification for better performance.
How do interest rate changes affect the value of bank assets and liabilities? ›
Changes in interest rates also affect a bank's underlying economic value. The value of a bank's assets, liabilities, and interest-rate-related, off-balance-sheet contracts is affected by a change in rates because the present value of future cash flows, and in some cases the cash flows themselves, is changed.
