How Interest Rate Changes Affect the Profitability of Banking

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.

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.

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 20^th century. 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.

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.