Higher interest rates can be both good and bad for banks, and the overall impact depends on how fast rates rise, how high they go, and the economic conditions surrounding the increase.
How banks make money
Banks primarily earn profits through net interest income:
- They pay interest on deposits and other short-term funding.
- They earn interest on loans and longer-term assets (mortgages, business loans, bonds).
The difference between what banks earn and what they pay is called the net interest margin (NIM). Interest rate changes directly affect this margin.
Why higher interest rates are often good for banks
Higher net interest margins
When interest rates rise:
- Loan rates usually adjust faster than deposit rates.
- This widens the spread between interest income and interest expense.
- As a result, banks earn more on each dollar they lend.
This is especially true for:
- Variable-rate loans
- Credit cards
- Short-term business loans
Increased income from new lending
- New loans are issued at higher interest rates, meaning:
- Each new mortgage or business loan generates more income.
- Even with lower loan volumes, higher pricing can boost revenue.
Improved earnings in a strong economy
Interest rates are often raised because the economy is strong or inflation is rising. In those conditions:
- Borrowers are more likely to repay loans
- Default rates remain low
- Banks benefit from higher rates and healthy credit conditions
Why higher interest rates can be bad for banks
Rising loan defaults and credit risk
As rates rise:
- Monthly payments on variable-rate loans increase
- Households and firms may struggle to service debt
- Delinquencies and defaults tend to rise
This forces banks to:
- Set aside more money for loan losses
- Reduce profitability
Reduced demand for loans
Higher rates discourage borrowing:
- Fewer people take out mortgages
- Businesses delay investment
- Consumers reduce spending on credit
Losses on bond portfolios
Banks hold large amounts of bonds. When interest rates rise:
- Bond prices fall
- Long-duration bonds lose the most value
If banks must sell these assets to meet liquidity needs, they may realize large losses.
Higher funding costs and deposit competition
As rates rise:
- Depositors demand higher interest on savings
- Some move money to higher-yield alternatives like money market funds
This increases banks’ cost of funding and compresses margins over time.
Higher interest rates are not inherently good or bad for banks.
They are:
- Positive when increases are moderate and the economy is strong
- Negative when increases are sharp, prolonged, or lead to recession
In short, banks benefit from higher rates until credit risk, funding costs, or asset losses overwhelm the gains.
Lauren Hua is a private client adviser at Fairmont Equities.
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