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I've read this claim many times in the news: banks are making less profit from the lending business when interest rates are historically low.

Isn't this a bogus claim? Let me clarify: To loan money out, the bank either needs to accept deposits from its clients, or borrow money from the central bank. Both of these operations are costly for the bank (they have to pay the deposit rate to the clients, or pay the central bank's rate for loaning funds from them). Thus, the profit from the bank's lending business is the difference between the interest rate charged from the borrowing client and the interest rate that the bank has to pay for the funds. Hence, profit has nothing to do with the level of interest rates. Is this correct?

lopta88
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3 Answers3

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profit has nothing to do with the level of interest rates. Is this correct?

In theory, yes. The difference that you're getting at is called net interest margin. As long as this stays constant, so does the bank's profit. According to this article:

As long as the interest rate charged on loans doesn't decline faster than the interest rate received on deposit accounts, banks can continue to operate normally or even reduce their bad loan exposure by offering lower lending rates to already-proven borrowers.

So banks may be able to acquire the same net interest margin with lower risk. However the article also mentions new research from a federal agency:

Their findings show that net interest margins (NIMs) get worse during low-rate environments, defined as any time when a country's three-month sovereign bond yield is less than 1.25%.

So in theory banks should remain profitable when interest rates are low, but this may not actually be the case.

Nosrac
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I've read this claim many times in the news: banks are making less profit from the lending business when interest rates are historically low.

The issue with most loans is they can be satisfied at any time. When you have falling interest rates it means most of the banks loans are refinanced from nice high rates to current market low interest rates which can significantly reduce the expected return on past loans. The bank gets the money back when it wants it the least because it can only re-lend the money at the current market (lower) interest rates. When interest rates are increasing refinance and early repayment activity reduces significantly.

It's important to look at the loan from the point of view of the bank, a bank must first issue out the entire principal amount. On a 60 month loan the lender has not received payments sufficient to satisfy the principal until around 50th or 55th month depending on the interest rate. If the bank receives payment of the outstanding amount on month 30 the expected return on that loan is reduced significantly.

Consider a $10,000, 60 month loan at 5% apr. The bank is expected to receive $11,322 in total for interest income of $1,322. If the loan is repaid on month 30, the total interest is about $972. That's a 26% reduction of expected interest income, and the money received can only be re-lent for yet a lower interest rate.

Add to this the tricky accounting of holding a loan, which is really a discounted bond, which is an asset, on the books and profitability of lending while interest rates are falling gets really funky.

And this doesn't even examine default risk/cost.

Martin Argerami
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quid
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Banks make less profit when "long" rates are low compared to "short" rates.

Banks lend for long term purposes like five year business loans or 30 year mortgages. They get their funds from (mostly) "short term" deposits, which can be emptied in days.

Banks make money on the difference between 5 and 30 year rates, and short term rates. It is the difference, and not the absolute level of rates, that determines their profitability. A bank that pays 1% on CDs, and lends at 3% will make money. During the 1970s, short rates kept rising,and banks were stuck with 30 year loans at 7% from the early part of the decade, when short rates rose to double digits around 1980, and they lost money.

Tom Au
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