Why banks love, and fear, interest rates
Higher rates can fatten a bank’s profits. They can also sink one. It depends on what the bank owns and who its depositors are.
Key points
- A bank’s core profit is the gap between what it earns on loans and what it pays on deposits.
- Rising rates help only while deposit costs rise more slowly than loan yields.
- In 2023, Silicon Valley Bank showed how long-dated bonds and flighty deposits can turn higher rates into a crisis.
Banks borrow short and lend long. They take in deposits that customers can withdraw at any time and turn them into mortgages, business loans and bonds that pay back over years. The difference between the interest they earn and the interest they pay is called net interest income, and for most banks it is the biggest source of profit.
That makes interest rates the most important number in banking, but not in the simple way headlines suggest.
How rising rates help
When central banks raise rates, new loans and floating-rate loans start paying more almost immediately. Deposits, especially everyday checking accounts, reprice slowly: many customers never move their money, and banks are in no hurry to pay them more. For a while the gap widens and profits rise.
Analysts track this with the deposit beta: how much of a rate increase a bank passes on to depositors. A low beta means the bank keeps more of the benefit. Big banks with millions of small accounts usually have the lowest betas, because their customers value convenience over squeezing out the last fraction of a percent.
How they hurt
The benefit fades. Customers eventually move cash into higher-paying savings accounts or money-market funds, and the bank has to pay up to keep them. Higher rates also make borrowing more expensive, which slows loan demand and pushes some borrowers into default. Banks set money aside for expected losses, and those provisions come straight out of profit.
There is a quieter risk too. Bonds a bank bought when rates were low lose market value when rates rise. Held to maturity, they still pay back in full, so the loss stays on paper. Forced to sell early, the bank turns that paper loss into a real one.
What 2023 taught everyone
That is what happened to Silicon Valley Bank in March 2023. It had put a large share of its deposits into long-dated bonds, and many of its depositors were tech companies with balances far above the insured limit. When those customers started withdrawing at once, the bank had to sell bonds at a loss, word spread, and the withdrawals became a run. It failed within days, and other regional banks with similar profiles followed.
Large, diversified banks came through that period largely intact, and some gained deposits from customers looking for safety. The episode changed what investors check first: not only how much a bank earns, but how stable its deposits are and how exposed its bond portfolio is to rate moves.
What to look at in a bank’s results
- Net interest margin: is the gap between loan yields and deposit costs widening or narrowing?
- Deposit trends: are customers leaving, or moving into more expensive accounts?
- Credit costs: are provisions for bad loans rising faster than the loans themselves?
- Unrealized bond losses: how big would the hit be if the bank had to sell?
Falling rates reverse much of this logic. Loan yields drop quickly while deposit costs follow with a lag, which can squeeze margins at first, even as cheaper borrowing helps borrowers keep up with their payments.