Questions America Wants Answered: "Are Rising Interest Rates Really Good for Banks?"

From EconoMonitor:

As the stock market soars to one record high after another, analysts do not hesitate to tell us why. One popular explanation is that expectations of higher interest rates are pushing up the stocks of banks and other financial companies  (example). Yet not so long ago, the same analysts were telling us that Wall Street in general and banks in particular were getting rich on the “free money” that the Fed was supplying to them at historically low rates (examples here and here). What gives?

To understand how interest rates affect bank profits, we turn to a wonky concept of financial economics known as the duration gap. Setting the precise mathematics to one side (read this if you really care), the duration gap refers to the difference between the maturity of a bank’s assets and its liabilities. If a bank funds itself with from short-term sources like deposits and uses those funds to make fixed rate mortgage loans or buy long-term bonds, then it has a positive duration gap. Interest rates tend to be higher on long-term financial instruments than on those with short maturities, so is the way banks traditionally made a profit.

The downside of the traditional banking model is that a positive duration gap means that profits fall when interest rates rise.  Suppose, for example, that your bank makes 30-year fixed-rate mortgages and funds them with deposits that pay an interest equal to the federal funds rate (the rate on overnight loans that the Fed uses at its primary interest rate target). If the loans earn 4 percent and the fed funds rate is 0.5 percent, you have a nice spread of 3.5 percent  between return on assets and cost of funds, allowing a good profit even after deducting  operating expenses.  However, if short-term rates went up, your bank would be in trouble. If the fed funds rate went up to 2 percent while your old fixed-rate mortgages still brought in just 4 percent your spread would be cut to 1.5 percent and your profits, after operating expenses, might evaporate altogether.

Modern banks have ways to reduce the interest rate risk inherent in traditional banking. One of the simplest strategies is to make variable-interest loans. If your funds come from short-term deposits, forget fixed-rate mortgages. Instead, make loans with rates that reset every twelve months according the movement of the federal funds rate or some other short-term interest rate. Suppose that today, you are receiving 3.5 percent on your variable rate mortgages (a little less than if you would earn  on fixed rate loans), and you are paying 0.5 percent on deposits. Tomorrow, short-term rates go up and you have to raise your deposit rate to 2 percent, but you also reset the mortgage rate to 5 percent. Same 3 percent spread, same profit, as before.

More complex strategies make it possible for banks even to engineer negative duration gaps while still maintaining their traditional business of taking in deposits and making loans. A bank with a negative duration gap would profit from rising rates and suffer a loss if rates fell....MORE