The central bank determines its lending rates to banks based on economic conditions and inflation; lower rates encourage businesses and consumers to borrow, thus adding fuel to the economy.
Banks can reduce their exposure to interest rate changes through derivatives. However, this can be difficult when the interest-rate sensitivity of assets and liabilities differ.
Increased Profitability on Loans
An increase in interest rates can boost a bank’s profitability by widening the spread between what customers owe them and what the bank makes from investing their deposits in short-term securities. For instance, banks holding $1 billion deposits, offering customers interest at 1 percent and earning 2 percent from short-term investments, could see earnings jump by $30 million with just an 1% interest rate increase to 3 percent.
Higher interest rates also depress valuations on longer-lived assets like mortgage-backed securities and loans, leading to valuation losses at banks due to repricing gaps (Brunnermeier & Koby 2018).
Hedging strategies designed to limit such gaps are frequently seen as key tools in mitigating banks’ exposure to interest-rate fluctuations, yet doing so can be challenging due to banks’ heavy exposure to securities whose price fluctuations affect non-interest income and net worth, creating capital gains or losses which are hard to measure and hedge against.
Increased Risk of Losing Deposits
As interest rates decrease, banks typically experience reduced deposit yields and earnings from short-term debt securities investments; as a result, their net interest margins (NIMs) diminish further. Furthermore, this lower cost of funding can lead to increased competition for deposits among customers looking for greater returns from their cash holdings.
However, lower interest rates can help promote economic growth while making businesses and consumers more resilient against any future recessions. This can reduce banks’ loan impairment expenses and any price declines on assets they use as collateral for loans.
Effects of interest rate changes on bank profits vary significantly by institution and time. Altavilla et al find that lower interest rates are associated with reduced profits at European banks; however, their effect is small due to economic activity increasing with reduced rates; therefore offsetting any potential negative effect on NIMs.
This year has witnessed an increase in interest rates that has reduced the value of bonds held as investments by banks, leading to unrealized losses that can have serious ramifications on market valuation and ability to sell securities. Banks can reduce this risk by diversifying revenue streams and increasing fee income – for instance many Danish smaller banks have focused on expanding wealth management and investment banking offerings as one way of mitigating risk.
Lower Profitability on Investments
Banks benefit when interest rates increase as investments such as cash and short-term debt securities yield greater returns; however, these profits could be offset by customers opting for alternative savings vehicles like noninterest-bearing checking accounts or term deposits that offer higher yields.
Higher interest rates often signal healthy economic expansion, leading to greater loan demand from both businesses and consumers alike. Lower borrowing costs enable individuals to expand more quickly while households have additional disposable income to spend.
Average Net Interest Income (NII) for large banks rose by 20% in Europe and 40% in North America between 2020-2021, though these gains could be partially offset by returning operating expenses to pre-GFC levels and an increase in loan loss provisions.
As evidence of interest rate changes on bank profitability reveals, short-run effects generally are either negligible or modest. Indeed, studies consistently demonstrate that lower rates result in narrower NIMs; however, their negative effects are offset by increased fee revenue and decreased loss provisions – this phenomenon being particularly applicable for small banks that are particularly sensitive to narrowing NIMs.
Lower Profitability on Short-Term Debt Securities
Low interest rates tend to decrease banks’ reliance on short-term debt securities that pose greater risk, though this also decreases profitability as they can no longer take advantage of yield spread between short-term debt securities and other forms of investment (such as stocks and corporate bonds ).
Bank-level data reveal that a one percentage point drop in short-term policy rates reduces NIMs and ROAs by an average of five basis points, though its effect can be mitigated in negative interest rate regimes due to other mitigating factors.
One possibility is that lower interest rates lower loan-loss provisions by lowering servicing costs and default risks, while another possibility is that banks become more selective in their lending practices, choosing shorter-term debt with longer maturities as investments in other asset classes. Either way, we don’t find evidence to show that this decrease in loan loss provisions by banks would offset by riskier behavior – as would be evidenced by increased hedging sensitivity – increasing risk-taking by banks would do exactly the opposite of what’s intended here.
Overall, our results indicate that changes in interest rates have a strong influence on banking profitability; however, their precise impact is complex. To gain greater insight into this topic, our study uses confidential bank-level data supplemented with survey information for further sharpening existing cross-country empirical evidence regarding rates and profitability associations. By employing bank-level variables we were also able to account for macroeconomic and funding conditions which may have an indirect correlation with profitability due to their effect on state of economy or financing conditions; using lags we constructed controls against these influences so as to account for within-bank serial correlation.
In conclusion, understanding the impact оf interest rate changes оn banking profitability іs crucial for financial institutions. Strategies such as hedging and diversification help mitigate risks associated with fluctuating rates, while also influencing profitability. For homeowners seeking financial solutions, options like a 2nd mortgage offer flexibility amidst evolving interest rates. Additionally, staying informed about updated rates from banks and financial institutions can guide decision-making regarding borrowing and investing. By carefully navigating these dynamics, both banks and borrowers can adapt tо changing economic conditions and optimize their financial outcomes.
