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)


How interest rates affect bank's profitability? ›

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 the Fed interest rate affect banks? ›

“Banks are not required to line up their interest rates with the Fed's rate, so each bank will respond to the Fed's rate announcement and adjust rates in their own way.” And while mortgage rates generally follow the Fed, they can often — and quickly — become disjointed.

How interest rates affect financial performance of commercial banks? ›

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.

Why are banks more profitable 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).

What happens to banks when interest rates rise? ›

Banks, brokerages, mortgage companies, and insurance companies' earnings often increase—as interest rates move higher—because they can charge more for lending.

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.

How does inflation affect bank profits? ›

In conclusion, our research demonstrates that unexpected increases in inflation tend to have a contractionary effect on the banking sector . Inflation-exposed banks respond by reducing lending, which, in turn, impacts house prices and construction employment.

Does interest rate affect banks? ›

Interest rates affect banks through earnings, lending, funding costs, and the fair value of assets.

Why do banks follow the federal interest rate? ›

Banks often need to borrow money from other financial institutions overnight to meet regulators' reserve requirements—or they may end up with excess reserve capital to lend out to their peers. The federal funds rate provides a reference for institutions as they are borrowing or lending reserves.

How does Fed interest rate affect savings accounts? ›

While some banks take their interest-rate cues from the fed-funds rate, it's far from universal. In fact, the average savings account interest rate was recently less than half a percent, with several of the biggest banks paying as little as 0.01%.

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.

Who makes money when interest rates rise? ›

In periods of rising interest rates, certain types of companies may benefit more than others. One example are bank stocks. Banks make money from the interest they charge on loans.

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).

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 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.


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