Interest Rate Changes Affecting the Profitability of Banking

The general tendency is that a period of higher economic growth will be accompanied by higher interest rates, and a stronger economy may mean that more customers will take out loans. One might therefore draw the conclusion that rising interest rates make bankers a happier bunch overall. On the other hand, this is not always the case. Let’s dive deeper.

How banks win when Rates Rise

1. The interest rate is the price that a lender charges a borrower for the privilege of temporarily borrowing money from the lender. A rise in interest rates is bad for borrowers because they will have to pay more, but it is good for lenders because they will earn more money.

2. When rates go up, the profit margin for banks goes up, even though their expenses don’t change (the rate they charge on deposits), and their income might go up (the rate they charge on loans).

3. One would think that the interest rates paid on deposits would also go up, but in reality, this only happens very infrequently. In the current environment, where there is an abundance of liquidity, there is little incentive for financial institutions to increase their deposit rates and decrease their profit margins. Deposit interest rates will, without a doubt, also go up at some point in the future; however, this will not take place until a later time, when financial institutions will be in a position to generate larger profit margins.

4. Additionally, the opposite is also true. In the event that interest rates continue to decline, financial institutions are likely to reduce the rates they charge for deposits more drastically than the rates they charge for loans. Between March and May of 2020, the Reserve Bank of India (RBI) reduced the policy repo rate by 115 basis points. During this time period, there was a decrease of 122 basis points (bps) in the weighted average lending rates (WALR), and there was a decrease of 150 bps in the rates for medium-term deposits.

5. Since there is a greater spread between the rate that the RBI policy rate is currently at and the rate that the bank charges its customers, the profitability of loans also increases when interest rates go up. The difference in interest rates between the short-term and long-term tends to widen whenever there is a change in the federal funds rate because long-term rates have a tendency to increase more quickly than short-term rates. Because banks borrow on a short-term basis and lend on a long-term basis, this is also beneficial to the banking industry.

6. While the vast majority of the money that banks borrow comes from customers’ deposits at low interest rates, some of that money also comes from bonds, markets, and other sources. The benefit from increased revenues may be offset, albeit to a much lesser extent, by the rising cost of borrowing money for them, which is caused by rising interest rates.

When Increasing Interest Rates Could Be Dangerous For Banks

On the other hand, when rates rise, the value of banks’ bond portfolios drops, which is a negative consequence of the rise in rates.

This is the case because of the inverse relationship that exists between bond prices and interest rates. The interest income that various bonds provide puts them in direct competition with one another. When interest rates rise, new bonds are issued at a higher rate and produce a greater amount of income than before. However, issuers of fixed-rate bonds are unable to raise their rates to the same level as new issues of bonds in order to maintain their attractiveness when interest rates rise. Because of this, lowering the price of the bond is the one and only way to boost competitiveness and bring in new investors.

To begin, the following is a list of the most significant events that occurred during the past year

1. The report highlights the negative effects of the war between Russia and Ukraine, stating that the global macro outlook is clouded due to the high costs of the war and the sanctions that have been imposed. In addition, even though they were just bystanders, developing economies and emerging markets like India have had to take the brunt of the negative effects of the spillovers.

2. An aspect of the war that is connected to an increase in the price of crude oil, metals, and fertiliser, which has resulted in a shock to terms of trade, is as follows: In the meantime, the central bank has been forced to deal with capital outflows and a significant depreciation in the value of the currency.

3. In 2021-22, India’s merchandise exports reached a record high of $421.9 billion, despite the challenges that the country faced.

4. There have been some positive developments with regard to taxation: after the COVID-19 pandemic, the states’ revenue and capital receipts have shown signs of strong recoveries. In addition, the central tax devolution came in significantly higher than the centre had anticipated.

5. The gross non-performing asset ratio of scheduled commercial banks has dropped to its lowest level in the past six years. The NBFCs’ balance sheets grew larger, but the quality of their assets got worse during this time.

6. The balance sheet of the RBI shows that in the fiscal year 22 they transferred Rs 1.14 lakh cr to the contingency fund. The quantity of notes available is 2.22 lakh pieces, which is a decrease of 0.36 percent from 2020-21.

7. Revenue and payments to the government: The total revenue for fiscal year 22 was 1.60 trillion rupees, which is an increase of 20 percent from the previous year’s total of 1.33 trillion rupees. Compared to Rs. 99,122 crore the previous year, the surplus was transferred to the government at Rs. 30,307 crore.

Conclusion 

It also warns that negative externalities have already begun to ripple through financial and commodity markets, and that rising prices for food and fuel are having a negative impact on those who are already at a disadvantage. As a result, it is anticipated that the global recovery will experience a significant loss of momentum in the year 2022.