What Happens to Banks When Interest Rates Rise?

Interest rates have been so low for so long that many people take them for granted. Federal Reserve Chairman Ben Bernanke has promised to keep rates low through 2014, but after that, rates could begin to rise. This will make for some interesting changes in how banks do business and how much profit they can expect. Low rates have actually benefited banks in some ways, so an era of higher rates could bring challenges.

According to the "New York Times," banks make more money on mortgage loans when rates are low. That's because banks can offer historically low rates to borrowers, but these "low" rates get set at a much higher profit percentage than usual. The perception that rates are low allows the bank to bump rates up by a half a percentage point and still offer a bargain. The bank then pays for that mortgage by selling bonds to investors at a low rate of return. The "interest spread" between what the banks pay investors and what they receive from borrowers has boosted profits.

This trend could reverse in an environment of rising rates. Banks might have to lower the mortgage interest rate because it won't look like such a bargain, and they may have to pay more interest to borrowers. The interest spread would narrow.

Banks may offer more credit when interest rates rise. As Silvio Cascione of Reuters points out, though it might seem like rising rates would decrease borrowing, the opposite may be true. Rising rates would signal a recovering economy, and optimism could encourage businesses and homebuyers to seek loans to lock in rates before they get higher. Banks could profit from the increased volume of loans, even if they make slightly less on each one.

As interest rates rise, banks have an opportunity to make more money on their investments. This makes bank stocks attractive to investors, who tend to value stocks based on the potential of the underlying companies to expand profits. Increased stock value could improve bank credit ratings and status, making it easier for banks to borrow money at lower rates. This would contribute to further gains in bank stocks.

Banks were notoriously cautious about lending during the 2008 to 2009 recession and even during the slow recovery. Rising rates, with the accompanying economic expansion, would put banks in a position to take higher risks, such as loaning to customers with less-than-stellar credit ratings. While banks would presumably stop short of the wild speculation that characterized the housing bubble, they could afford to loan money to someone whose credit wasn't perfect. A rising job market and improved economy would inspire optimism that medium-quality borrowers would be able to keep up with loan payments.