By Harrison Heaton
Anytime there is a concept that benefits one group of society and harms the other, there is going to be great emotion and importance surrounding it. When that concept has an immediate effect and correlation to your finances, it becomes an even greater deal. The concept of interest rates have been influencing borrower behavior for centuries and originated at the beginning of the dawn of time.
Institutions within the banking sector such as Retail Banks, Investment Banks, Insurance Companies and the one I want to talk about specifically today in Commercial Banking, all have varying calibers and degrees of financial holdings in assets due to their customers and business activities. Whether they are more profitable or not, is all based on whether they have more rate sensitive assets within their portfolio, or the opposite with rate sensitive liabilities. Commercial Banks or the financial banking sector as a whole, are extremely profitable in times of hikes among interest rates from the FED (Federal Reserve). This is due to them having a favorable ratio of assets to liabilities.
The main money makers for these commercial banks are the issuance of loans, mortgages, debt, etc. to their borrowers in which interest on the debt must be paid for them giving the money. Now there are a multitude of risks that come with the issuance of this money such as credit risk, market risk, etc. but if everything goes according to plan, borrowers must pay back the loan/mortgage with the respected interest which all is derived from the FED and their established baseline interest rate. If interest rates go up by a certain amount of basis points, it directly makes the cost of borrowing money more expensive for the consumer and therefore gives banks more money in their pocket. However, when interest rates decrease, basing financial decisions to have a more even portion of assets to liabilities may be a smart investment position, due to the interest rate, at which you have to pay back your liabilities, lowering, therefore making it more affordable and cheaper to borrow money.
To boil it down, increases in interest rates directly increase the yield on assets which further attributes to earnings in the bank. The best way to simplify this, is to provide an analogy. When the price of oil goes up, the oil companies that drill the oil are foaming at the mouth due to more money coming in. The profit these commercial banks incur simply put are the marginal differences in the profit they receive from the yield of their respective time assets, and the interest they pay out through their liabilities. This marginal gap between the interest inflow and the interest payout on their respective assets and liabilities within a given time bucket is known as the cumulative gap and the ratio mentioned above is the cumulative gap ratio. Yet, this gap goes off book value numbers and doesn't take into account the items that are off the balance sheet.
These interest rate fluctuations are present in everyday life, and especially prominent in today’s economy. Covid-19, which is a market risk, has influenced interest rates to bounce in the past 2ish years, making it hard for commercial banks to be as profitable as they previously were. Obviously, when a large and deadly pandemic hits, it affects the well being of everyone especially when it comes to occupying a job and earning income. When the pandemic first started, job losses were at a record high, businesses were going out of business left and right, and people were struggling to make economic ends meet. Therefore, the FED lowered interest rates making the ability to borrow money much cheaper in the near but mostly long run. With these rates lowering, obviously commerical banks were less profitable due to them not receiving as much money on interest as before. However, even though interest rates went down making commercial banks less profitable, the volume of people getting home loans and mortgages went up by a substantial amount due to the cost of borrowing to get cheaper. Recently the FED cut interest rates down by 100 basis point following a previous 50 basis point cut in March of this year. This will likely cause a 1% decrease in interest rates which makes a huge difference in the ability to pay back these loans, credit cards, mortgages, etc.
In the image above, we can see a breakdown of the FED interest rate within the past 15 years and some events that influenced the movement. On the far right, we can see when covid was officially declared a pandemic, and the corresponding basis point drops that I mentioned above almost lowered the rate to 0%. However, there has been recent talk about increasing the FED’s rate because Covid still being very deadly, did not have the same effect it had on the economy in its early stages. It would not be surprising if this rate went up by a certain amount of basis points which again would favor the banks/financial institutions, and make it more expensive for the borrower to obtain debt because more people are getting back to work.
Now I have been talking a lot about how when interest rates go up usually the commercial banks profitability goes up due to them having more rate sensitive assets than liabilities, and how the opposite works with a decrease in the FED rate. However, this is a very simple concept that actually has much more depth to it. Maturity on these assets and liabilities are the most vital factor when it comes to calculating how much net interest income you receive or lose. Maturity is the timeframe that these assets or liabilities take to pay or be paid off. An example would be something like a 30 year mortgage compared to a 15 year mortgage, in which interest rate fluctuations and especially interest rate increases would have more of an influence on the longer term maturity mortgage I.E the 30 year. The longer the loan term the higher the risk.
Interest rate changes usually result from a freak economic downturn or to stimulate growth in a lagging economy. Making it cheaper to borrow money spurs hiring, investing, and consumer spending. Leading up to the financial crisis, the FED lowered interest rates due to them realizing people were not being able to pay back their mortgages after these commercial banks were just giving them out like candy. Therefore, during and after this financial crisis that negatively impacted the lives of every American, the FED rate hovered right above 0% for the next 8 year. From 2015 to 2018, the FED increased interest rates 9 times. 3 times in 2019, 2 times in 2020 to try and curb the slowness of the economy into the pandemic.
The biggest factor that goes into the success and advancement of commercial banks or matter of fact the entire financial industry is the people. Me, you, our friends, loved ones, all have an integral role in the function of these institutions. Therefore, banks profit when they issue out more loans and receive interest on these loans meaning they want a higher FED interest rate to land more net interest income. However, while raising the interest rates are great for banks, they make it more costly to invest and thrive to the everyday working class. In the visual above, we can see a glimpse into the past of the inverse relationship between interest rates and the S&P 500 growth. If you look at the visual below it is the same story but for a more recent time frame to show that this natural inverse relationship of cyclical bouncing is apparent and is very obvious to the eye.
This not only makes it harder for people to obtain the debt needed to purchase homes or receive loans for a plethora of reasons, but it also makes it harder for the working class to enter the stock market because of the decline in growth as there is an incline in interest rates. Simply put, when interest rates go up it takes more money out of the investors pocket. Further suggesting that while it is beneficial to the bank's profitability, it harms the everyday individual. So, to reiterate commercial banks and their relationship to interest rate hikes is great for some, but bad for others and goes back and forth between the bank and the borrower often favoring the bank.
Work Cited
Desjardins, Jeff. “Chart: The Downward Spiral in Interest Rates.” Visual Capitalist, 17 Mar. 2020, https://www.visualcapitalist.com/chart-the-downward-spiral-in-interest-rates/.
General Securities Principal Qualification ... - Finra.org. https://www.finra.org/sites/default/files/Series_24_Outline.pdf.
Blodget, Henry. “Yes, Stocks Could Drop 50%.” Business Insider, Business Insider, 31 July 2014, https://www.businessinsider.com/stock-market-crash-2014-7.
Morello, Robert. “How Do Commercial Banks Make Money?” Small Business - Chron.com, Chron.com, 21 Nov. 2017, https://smallbusiness.chron.com/commercial-banks-make-money-55763.html.
“How Do Interest Rates Affect Investments?” Consumer Banking, 4 May 2021, https://www.usbank.com/financialiq/invest-your-money/investment-strategies/how-do-interest-rates-affect-investments.html.
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