Explained: How rising interest rates affect banks

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One would assume that rates on deposits would also rise, but this rarely ever happens in tandem. There is little incentive for banks to raise deposit rates and cut their profit margins, especially in the current situation where liquidity is plenty. Sure, at some point deposit rates too will rise, but that only happens with a lag, by when banks are able to make fatter profit margins.

The reverse also holds true. In a falling rate scenario, banks are more inclined to make steeper cuts in deposit rates, compared to lending rates. In 2020, the RBI cut policy repo rate by 115 basis points between March and May. During this period, the weighted average lending rates (WALR) went down by 122 bps, while the medium-term deposit rates went down by 150 bps.

As interest rates rise, profitability on loans also increases, as there is a greater spread between the RBI policy rate and the rate the bank charges its customers. The spread between long-term and short-term rates also expands during interest rate hikes because long-term rates tend to rise faster than short-term rates. This also helps banks since they borrow on a short-term basis and lend on a long-term basis.

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While the bulk of banks' borrowing is from low-cost deposits, some portion of their borrowing is also from bonds, markets, etc. Rising interest rates also raise borrowing costs for them, and may offset the benefit from higher revenues, but to a much smaller extent.

On the flip side, however, when rates rise, banks’ portfolios of bonds become less valuable.

This is so because bonds and interest rates have an inverse relationship. Bonds compete against each other on the interest income they provide. When interest rates go up, new bonds come with a higher rate and provide more income. But fixed-rate bond issuers can’t increase their rates to the same level as the new issue bonds when rates go up in order to stay attractive. Thus, the only way to increase competitiveness and attract new investors is to reduce the bond's price.

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This is why when rates rise for an extended period, bond prices decrease, making banks' bond portfolios less attractive.