Why banks want higher interest rates (and it’s not what you think) (2024)

So, when the RBA lifted interest rates by a quarter of a percentage point on Tuesday, the cost of borrowing money, in the overnight market from other banks, also went up by 0.25 per cent.

This overnight rate is the anchor for all other short-term lending rates in the market, such as the rate for lending over one-month, three months and so on. That’s because if a bank can earn a certain interest rate for lending money overnight, it will demand a higher rate for extending money for longer terms.

In fact, the three-month bank bill swap rate (BBSW) is the commonly used reference rate upon which most lending rates across the economy are priced.

Why banks want higher interest rates (and it’s not what you think) (1)

So, when the overnight interest rates are increased by the RBA, base interest rates across the economy go up.

To offset this increase in base interest rates, the banks simply increase the rate they charge borrowers, such as customers on variable mortgage rates.

All things being equal, banks simply raise mortgage rates to neutralise this increase in the cost of money. That’s the intention.

How do the banks boost profit margins?

A higher home loan rate is basically the whole point of the RBA raising interest rates. By increasing borrowing costs in the economy, consumption is meant to slow, reducing demand and therefore upward pressure on prices.

The RBA might be annoyed if it had cut rates and the banks never passed it on, but it’s not likely to have any problems with banks raising rates the full amount.

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But there are a few moving parts within the banking system that means rising rates are good for banks, not simply because the absolute rate they charge borrowers goes up.

Why banks want higher interest rates (and it’s not what you think) (2)

One is that most loans written by Australian banks are financed by deposits. Some of these deposits, such as term deposits, pay relatively high-interest rates while some deposits, such as a savings or transaction account, don’t pay anything at all.

When interest rates are high in an absolute sense, the loans that are financed by those zero cost deposits are very profitable. But as rates fall and the banks lower mortgage rates, the margin benefit from those cheap deposits is diminished. When that process reverses, the banks benefit.

Another reason why banks prefer rising interest rates is that they have a fairly large pool of cash that is effectively sitting idle, and cannot be lent. This includes the cash it keeps on hand as capital that acts as a buffer for soured loans.

The banks invest these funds in ultra-safe assets, mainly three- and five-year bonds. But until recently three- and five-year interest rates have declined, reducing the interest income from this portfolio.

That trend is now reversing and the banks are reinvesting maturing bonds at a now higher rate, and that’s boosting their margins.

So, the banks do indeed win from higher interest rates but not simply because the absolute rate on your mortgage has increased.

What happened when the RBA last increased the cash rate?

When the Reserve Bank last raised interest rates in 2010, the banks were in a bind. They had increased their lending books so rapidly they had to look beyond household deposits toward wholesale bond markets to finance lending activities. But those markets turned hostile while they faced a scrap for the pool of deposits back home.

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This meant their funding costs were increasing faster than the RBA was raising rates, so they took the unpopular decision of raising rates by more than the central bank – something Australians were not used to.

Wholesale funding and deposit costs are less of an issue now as home loan growth has moderated while households are flush with cash sitting with banks.

So, it’s not likely we will see the banks move out of step with the RBA. If anything, there’s more competition now for home loans.

When do banks increase deposit interest rates?

Where the controversy may lie in 2022 is in deposit rates – and whether banks drag their heels on paying fair deposit rates as a means of protecting their margins.

This is where there has been a considerable change in behaviour. Before interest rates fell to near zero, banks had to compete for deposits (which they needed, to finance and expand their lending activities) by offering attractive term deposit rates.

But in a low rate world most customers moved to a savings account because there wasn’t enough of a reward for not having your money at all.

As rates go up, the banks are likely to find they’re having to compete for deposits by offering higher rates, which will increase their costs and reduce their profits.

Already we’ve seen forced action on deposit rates by the Big Four banks.

After the RBA announcement, CBA lifted its interest rate on 18-month term deposits (for those willing to place $5000 to $2 million in an account) by 1.95 percentage points.

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Meanwhile, ANZ Bank, Westpac, and National Australia Bank boosted their rates for various savings accounts by the same 25 basis points as the official cash rate rise.

How much will banks make from this rate increase?

Analysts have different views on just how much the banks will make from rising rates given all the variables involved.

Morgan Stanley estimates that for each quarter-point interest rate increase, the bank’s net interest margins will increase 3 basis points. That helps bank profits.

Macquarie estimates that over the next three years, higher rates will lift profits by about $1.6 billion, or around 3 per cent to 5 per cent.

But other analysts like Citi believe most of the gains will be eaten away as cheap pandemic funding rolls off and overall deposit interest costs increase.

Another twist is that as interest rates go up (which means investors get a higher income from a safe investment such as a bond or a deposit) investors may regard banks as relatively less-attractive investments, even if their profits are up. So bank shares may not go up, or fall.

How do banks profit from fixed versus variable home loan rates?

In the past two years there was a huge growth spurt in fixed rate home loans because they were so much lower than variable loans.

There’s a reason for this. That was amid the pandemic gloom, and central bank policies designed specifically to give borrowers confidence that rates would not go up, three-year borrowing rates were ultra-low.

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What this meant is that banks could borrow money or hedge their interest rate risk for three years and lock in a profit margin, and still offer customers an attractive three-year loan rate.

Now as interest rates have marched higher, three-year bond rates have surged. In fact, the RBA was forced to abandon its policy of pinning the three-year bond rate at 0.1 per cent.

The consequence is that anyone who wants to get a fixed rate home loan now has to pay a materially higher rate, that is now above a variable loan rate.

The expected path of interest rates

In theory though, fixed rates reflect the expected path of interest rates plotted by the market, which means if traders are right, variable rates are going up to a setting comparable with high fixed rates.

So, what does it mean for bank profits?

Well on balance it’s good because banks make slightly fatter margins on variable home loans versus fixed home loans. So, a shift in the mix toward variable mortgages improves their overall margins.

That relates to a final point on the Reserve Bank’s mea culpa. Lowe said rates weren’t going to go up for three years, and yet they are. If you took out a home loan, should you feel duped? Perhaps not.

His (ultimately broken) promise did matter in that it pegged three-year borrowing costs when he made it, and that in turn made three-year fixed rate home loans extraordinarily cheap.

Many Australians took advantage but when those terms expire they may be in for a shock when it’s time to renegotiate.

Why banks want higher interest rates (and it’s not what you think) (2024)

FAQs

Why banks want higher interest rates (and it’s not what you think)? ›

As the cost of funds increases, lenders will need to raise interest rates to compensate. Another thing lenders need to consider is inflation. When inflation is high, the government raises rates to deter borrowers from taking loans in an effort to reduce spending.

Why do banks like higher interest rates? ›

Meanwhile, for large banks like JPMorgan, higher rates generally mean they can exploit their funding advantages for longer. They enjoy the benefits of reaping higher interest for things like credit card loans and investments made during a time of elevated rates, while generally paying low rates for deposits.

Why are banks putting up interest rates? ›

We increased interest rates to slow down inflation. We need to see more evidence that inflation will stay low before we can cut interest rates.

Why do banks care so much about the real interest rate? ›

This is in part because higher interest rates are normally a sign of a booming economy. But profits rise mostly because the banks can earn a higher yield on every dollar they invest. Banks make money by accepting cash deposits from their customers in return for interest payments and then investing that money elsewhere.

Why are banks paying high interest rates? ›

Savings account rates are loosely linked to the rates the Fed sets. After the central bank raises its rate, financial institutions tend to pay more interest on high-yield savings accounts to stay competitive and attract deposits.

Who benefits from higher interest rates? ›

As interest rates rise, the interest income from loans typically increases faster than the interest paid on deposits, leading to wider profit margins. Additionally, higher interest rates can boost the earnings of insurance companies and investment firms, as they often hold large portfolios of interest-sensitive assets.

Why do interest rates have to be so high? ›

The main tool the Fed uses to manage the economy and implement monetary policy is setting its key interest rate, which influences borrowing costs. Whenever it needs to cool the economy by making borrowing more expensive, the Fed raises rates, which should then bring down inflation.

Why are banks allowed to raise interest rates? ›

When funding costs change, the response of lending rates will depend on the expected impact on a bank's profits. If funding costs increase, then a bank may wish to increase lending rates to maintain its profits. However, borrowers may seek to borrow less if lending rates are higher.

Why do federal banks raise interest rates? ›

The Fed raises interest rates to slow the amount of money circulating through the economy and drive down aggregate demand. With higher interest rates, there will be lower demand for goods and services, and the prices for those goods and services should fall.

What does it mean when banks raise interest rates? ›

A rise in interest rates often means that it will cost you more to borrow money. A rise in interest rates may affect you if: you have a mortgage, a line of credit or other loans with variable interest rates. you'll need to renew a fixed interest rate mortgage or loan.

Why are banks losing money? ›

In response to high inflation, the Federal Reserve Bank severely tightened monetary policy. From March 7, 2022, to March 6, 2023, the federal funds rate rose sharply from 0.08 percent to 4.57 percent. As a result, long-dated assets experienced significant value declines.

Does the government make money when interest rates rise? ›

The Fed also issues cash, which pays no interest, so the Fed makes steady money on the difference between interest-bearing assets and the zero return of cash. But when the short-term rates the Fed pays rise sufficiently to make its interest expenses greater than its interest earnings, the Fed loses money.

Why are banks allowed to charge such high interest rates? ›

Because it's risky to lend credit to millions of Americans with varying credit histories, issuers charge higher average APRs across their entire customer base. But keep in mind, you have some say in how much you pay interest: “Interest on a credit card is optional,” Ulzheimer says.

Why do banks benefit from higher interest rates? ›

The financial sector has historically been among the most sensitive to changes in interest rates. With profit margins that actually expand as rates climb, entities like banks, insurance companies, brokerage firms, and money managers generally benefit from higher interest rates.

Why are bank loan interest rates high? ›

Interest rates tend to rise with inflation. To combat inflation, banks may set higher reserve requirements, tight money supply ensues, or there is greater demand for credit. In a high-interest-rate economy, people resort to saving their money since they receive more from the savings rate.

Why are banks' interest rates so low? ›

Banks don't need your money

The banks will also adjust the savings rate based on the supply and demand of loans and deposits, as well as the policies of the Fed. If there is plenty of supply and people are saving a lot, then the banks will not need to pay out as much interest.

Why are high interest rates attractive? ›

Key Takeaways. Higher interest rates have gotten a bad rap, but over the long term, they may provide more income for savers and help investors allocate capital more efficiently. In a higher-rate environment, equity investors can seek opportunities in value-oriented and defensive sectors as well as international stocks.

Do banks make most of their money from interest? ›

They make money from what they call the spread, or the difference between the interest rate they pay for deposits and the interest rate they receive on the loans they make.

Are high interest rates good for borrowers? ›

Rate hikes make it more expensive to borrow, discouraging consumers from making large purchases and companies from hiring and investing.

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