why are higher interest rates good for banks?

There are two factors involved:

behavior of bank managements:  To a considerable degree, commercial banks are able to use changes in interest rates to their money-making advantage.  When rates are declining, banks immediately lower the interest they pay for deposits but they keep the rates they charge to borrowers high for as long as they can.

When rates are rising, as is the case in the current economic environment, banks do the opposite.  To the degree they can, and given that most loans are variable-rate that is considerable, they raise rates to borrowers immediately.  But they keep the interest rate they pay for deposits low for as long as they can.

A generation ago, banks had a much greater ability  than they do now to maneuver the interest rate spread.  That’s because money market funds were in their infancy.  There were no junk bonds to serve as substitutes for commercial loans.  There was even a Federal Reserve rule, Regulation Q, that prevented banks from paying interest on checking accounts and put a (low) cap on what they could pay to holders of savings accounts.

Nevertheless, especially as rates are rising, spreads still can widen a lot.

economic circumstances:   bank lending business tends to tail off in recession, since most companies don’t want to take the risk of increasing their debt burden during bad times–even if the potential rewards seem enticing.  The credit quality of existing loans also worsens as demand for capital and consumer goods flags.

The opposite happens during recovery.  The quality of the loan book improves and customers begin to take on new loans.

stock market effects

The market tends to begin to favor banks as soon as it senses that interest rates are about to rise.  Wall Street was helped along this time around when perma-bear bank analyst Mike Mayo turned positive on the group for the first time in ages last summer.

After the anticipatory move, banks have a second leg up when the extent of their actual earnings gains becomes clear.  It seems to me the first move has already come to an end   …but the second is still ahead of us.

One response

  1. Pingback: REIT Risk: Bank Borrowing On The Rise, Says Fitch - CRE Blog | CommercialSearch

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