HOW BANKS MAKE PROFIT AND AFFECT ON INTEREST RATES ON BANKING SECTOR
The banking sector's profitability increases with interest rate hikes. Institutions in the banking sector such as retail banks, commercial banks, investment banks, insurance companies and brokerages have massive cash holdings due to customer balances and business activities.
Increases in the Federal funds rate directly increase the yield on this cash, and the proceeds go directly to earnings. An analogous situation is when the price of oil rises for oil drillers. The benefit of higher interest rates is most notable for brokerages, commercial banks and regional banks.
Banking is a spread business. Banks profit from the gap between the interest rate they receive on their assets (mostly loans and securities) and the rate that they pay on liabilities (mostly deposits). Because banks engage in maturity transformation – with assets having a longer maturity than deposits – this lending spread will generally fall when the yield curve flattens.
Since banks hold fixed-income instruments (bonds and loans), higher interest rates across the yield curve reduce the present discounted value of their assets. And, the longer the duration of their assets (relative to their liabilities), the bigger those losses will be. Similarly, banks face greater risk when the volatility of their portfolios (and the correlations among their assets) rise.
Rising interest rates are often a signal of stronger economic growth. An improved growth outlook benefits banks in several ways. It reduces the risk that borrowers will default, increasing the value of bank assets. It increases credit demand at any given interest rate, potentially raising the volume of their lending business.