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alt text: the image of a Canadian multinational banking and financial services company Scotiabank
Even if policy rates are only slightly raised, banks will be able to charge much higher interest rates for borrowers without significantly increasing depositor payouts. This could help banks generate millions in revenue. Rising interest rates also indicate economic expansion, and more borrowers may take out loans if the economy is stronger. Thus, profitability in the banking industry rises when interest rates rise, and we can draw the conclusion that banks like high-interest rates.
Due to business activities and customer balances, financial companies in the banking industry, including investment banks, commercial banks, retail banks, brokerages, and insurance companies, have enormous cash holdings. The return on these cash holdings will increase with increasing interest rates. Commercial banks, regional banks, and brokerages profit the most from increasing interest rates. Trading is also affected by interest rates.
How do banks make money when interest rates are high?
The cost a lender imposes on a borrower for a short-term loan is known as the interest rate. Increasing interest rates, therefore, benefits lenders by increasing their income while hurting borrowers who must pay more. When interest rates go up, the profit margin of banks increases while the rate on deposits stays the same and the rate applied to loans can climb.
Although it would seem logical that deposit rates would increase as well, this rarely occurs simultaneously. Banks have little motivation to reduce the profit margins and hike deposit rates, particularly at a time with plenty of liquidity in the market. Deposit rates will eventually rise as well. But it will not happen until after banks have had a chance to increase their profit margins. The opposite is also true. In a situation where interest rates are falling, banks are much more likely to lower deposit rates sharply than lending rates.
The companies in the banking industry keep the money of their clients in savings accounts with interest rates that are lower than short-term rates. They make money from the small differential between the return they get from investing this money in short-term notes and the rate they offer their clients. This spread widens when rates climb, with the additional money going directly to earnings.
To understand this concept better, let us look at an example. Consider a brokerage firm with $10 billion in client accounts. This money will earn clients 1% interest, but the banking institution will make 2% on it by means of short-term investments. As a result, the bank will be earning $200 million from the accounts of its customers while only returning $100 million to them. Now consider a case where the federal interest rate increases to 3% and the central bank raises interest rates by 1%. In this case, the banking institution will earn $300 million on client accounts while paying clients $10 million in compensation. All these will raise the profit margins of banks tremendously.
Another way banks gain from high interest rates
The rise in interest rates frequently occurs in contexts of robust economic development and rising bond yields. These factors indirectly influence the banking sector’s profitability. Under these circumstances, the need for loans from consumers and businesses increases, which boosts bank profits.
When there is an increase in the interest rate, the gap between the federal interest rate and the interest charged by the banking institution widens, thereby increasing loan profitability. Since long-term rates often increase more quickly than short-term rates, the gap between these two also widens as interest rates are raised. Interest rates often rise due to inflationary pressures and powerful underlying conditions. Given that banks lend money for long periods of time and borrow money for short periods of time, this is an ideal set of circumstances for them.
Can rising rates hurt banks?
On the other hand, as rates climb, the value of banks’ bond portfolios declines. The reason for this is the inverse relationship between bonds and the rate of interest. Bonds often compete with one another in regard to their interest income. New bonds have a greater rate and produce more income whenever interest rates rise. However, bonds with a fixed rate cannot raise their rates in a way similar to these new bonds. The only option to boost competition and draw in new customers is, then, to lower the price of the bond. Due to this decline in bond values caused by prolonged rate increases, the bond portfolios of banks could become less desirable.
Tradingand interest rates
The effect of interest rates on trading is a bit different. Whenever there is an increase in interest rates, the stocks of industries like lifestyle essentials and consumer goods gain more success since the disposable income of people is lower. Since every economic situation is different, before deciding on which stocks to trade, it is always better to consult a good financial advisor. You may also consider using a reliable trading app likeiFOREX Europe CFD Trading to get accurate market analysis and state-of-the-art tools.
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