Higher Interest Rates and Bank Stocks: Why Rising Rates Aren't Always Good for Banks

Ben Tan

1 day ago

7 min read

There is a simple investment idea that gets repeated quite often:

Higher interest rates are good for banks.

And intuitively, it makes sense.

Banks borrow money at one rate.

They lend it out at a higher rate.

If interest rates go up, surely banks can charge borrowers more.

Higher lending rates.

More interest income.

More profit.

Simple.

Except the latest results from America's largest banks show why banking economics are rarely that straightforward.

JPMorgan, Citigroup, Wells Fargo and Bank of America all reported higher net interest income in their latest quarter.

Yet bank investors remain nervous.

Some bank shares actually fell after reporting otherwise respectable results.

So what's going on?

I think the answer gives us a useful lesson not just about banks, but about investing generally:

A change that benefits one part of a business can simultaneously hurt another.

And with banks, interest rates sit right in the middle of almost everything.

Bank infographic showing home, business and auto loans feeding interest income, and savings, checking, CD accounts earning interest expense.

First, Why Should Higher Interest Rates Help Banks?

Let's start with the basic economics.

Imagine a bank pays depositors 1% on their money.

It then lends that money to customers at 5%.

Very simplistically, that spread helps generate the bank's interest income.

Now imagine lending rates increase to 7%, while the bank still pays depositors only 2%.

The spread has increased.

Great.

This is why investors pay so much attention to net interest income, or NII.

Very simply, net interest income is the difference between the interest a bank earns on assets such as loans and securities, and the interest it pays to fund those assets.

Higher rates can therefore be very profitable for banks.

And we're seeing some of that today.

Bank of America's net interest income increased 8% in the third quarter, helped by higher loan and deposit balances as well as fixed-rate assets repricing at higher yields. JPMorgan, Citigroup and Wells Fargo also reported higher net interest income.

So the original statement isn't wrong.

Higher rates can benefit banks.

But that's only one side of the balance sheet.

The Problem Is That Depositors Notice Higher Rates Too

Imagine your bank continues paying you 0.5% on your savings account.

Meanwhile, you can buy a government security yielding 5%.

What would you do?

Eventually, some customers will move their money.

Or they'll tell their bank:

Pay me more.

And that's exactly what banks are dealing with.

Reuters reported that as US Treasury yields climbed, depositors increasingly searched for higher-yielding alternatives, forcing banks to pay more to keep their funding.

That's important because deposits are essentially the raw material of banking.

A bank doesn't only care about how much it earns from lending.

It also cares about what that money costs to obtain.

If the interest earned on loans rises by two percentage points, but the interest paid to depositors also rises by two percentage points, the economics haven't necessarily improved.

This is why another metric matters:

Net interest margin.

It tells us something about the spread between what the bank earns and what it pays for funding.

At JPMorgan, its deposit margin slipped to 2.78% from 2.79% a year earlier.

At Wells Fargo, taxable-equivalent net interest margin declined to 2.43% from 2.61%.

So while interest income may be rising in absolute dollars, the competitive battle for deposits can prevent all of that benefit from flowing through to shareholders.

That distinction matters.

Subscribe to our newsletter if you enjoy insights like this.

There Is Such a Thing as Rates Being Too High

Here's another problem.

Suppose you're thinking of buying a home.

At a 2% mortgage rate, the numbers work.

At 3%, perhaps they still work.

At 4%, you start reconsidering.

At 7%?

Maybe you don't buy at all.

The exact numbers will differ for every borrower, but the principle is straightforward.

Higher interest rates can increase what banks earn per loan.

But eventually, those same rates can reduce how many loans people want to take.

This applies to businesses too.

A company considering a new factory, acquisition or expansion project may happily borrow when financing costs 4%.

At 8%, the economics might no longer make sense.

Suddenly the bank has attractive lending rates...

but fewer attractive borrowers willing to borrow.

That's why investors are watching loan growth very closely.

So far, the numbers remain reasonably healthy.

Citigroup reported average loans up 12% year-on-year, Wells Fargo 11%, Bank of America 6%, and JPMorgan 2%.

But the question investors care about isn't merely what happened last quarter.

It is:

What happens if borrowing costs remain this high for another year?

Want a concise version of Charlie Munger’s 25 human misjudgements? Download here!

Cover reading Charlie Munger’s Psychology of Human Misjudgement, with a portrait of Charlie Munger in a suit on a pale green background.

Higher Rates Can Also Hurt Borrowers Who Already Have Loans

Then there is credit quality.

Imagine someone earns $10,000 a month and has $6,000 of monthly expenses.

They have room.

Now their mortgage payment increases.

Their car loan costs more.

Food and energy costs rise.

Suddenly that buffer gets smaller.

Nothing necessarily breaks immediately.

But the margin for error declines.

Banks care deeply about that margin because their profits depend not only on making loans, but on borrowers actually repaying them.

This is where higher rates start working against the bank.

The bank might earn an extra 1% on a loan.

But if enough borrowers default, that additional yield means very little.

So banks build provisions for potential future credit losses.

Both Wells Fargo and Citigroup increased their credit-loss provisions during the third quarter amid the more uncertain economic environment. Overall credit quality has not shown major cracks yet, according to analysts cited by Reuters, but investors are watching the direction carefully.

That word—yet—is important.

Credit problems often appear with a lag.

Blue financial infographic shows a bank between assets and liabilities, with rising funding costs, delayed repayments, and falling bond values.

Then There Is the Bank's Own Investment Portfolio

This is one of the more counterintuitive consequences of higher interest rates.

Banks don't only own loans.

They also hold securities.

Treasuries.

Mortgage-backed securities.

Government-agency bonds.

And when market interest rates rise, the value of existing lower-yielding bonds generally falls.

Why?

Imagine I own a bond paying 3%.

New bonds now pay 5%.

Nobody will pay me full price for my 3% bond when they can obtain 5% elsewhere.

The price of my existing bond has to fall until its economics become competitive.

Bank of America provides a striking example.

At the end of September, it reported around US$109 billion of unrealised losses on its securities portfolio, up from US$85 billion at the end of June as bond yields rose.

Much of those securities were classified as held-to-maturity, meaning the bank does not intend to sell them, so an unrealised accounting loss is not the same as an actual realised loss.

But the example illustrates something important:

Higher rates can simultaneously increase the yield on new assets while reducing the market value of old ones.

The same rate movement can help and hurt different parts of the balance sheet.

Higher Rates Don't Only Affect Traditional Lending

Modern banks aren't simply deposit-taking institutions.

Large banks earn substantial amounts from:

investment banking,

trading,

asset management,

wealth management,

payments,

credit cards,

and many other businesses.

And higher interest rates can affect those activities too.

If financing becomes expensive, companies may delay acquisitions.

Private-equity firms may find leveraged buyouts harder to finance.

Companies may postpone IPOs.

Debt issuance can slow.

That hurts investment-banking fees.

JPMorgan's third-quarter investment-banking fees declined 8% from the previous quarter, while CEO Jamie Dimon said activity had moderated.

Its fixed-income trading revenue also declined 4% year-on-year, although equities trading performed very strongly.

Bank of America's investment-banking fees fell 11%, while its fixed-income, currencies and commodities trading revenue declined 17%.

So again:

Higher rates might help the lending spread.

But if they also freeze capital markets, that benefit can be partly offset elsewhere.

Business and finance collage with modern office tower, people shaking hands, meetings, stock charts, savings piggy bank, and globe.

This Is Why I Don't Like Simple Investment Narratives

You see this constantly in investing.

Interest rates rise?

Buy banks.

Oil prices rise?

Buy oil companies.

AI adoption rises?

Buy AI stocks.

Property prices rise?

Buy developers.

There is usually some economic logic behind the statement.

But the logic is often incomplete.

With banks, I'd rather ask:

How sensitive is the bank's asset yield to rates?

How sensitive are its deposits?

How quickly must it pay customers more?

What happens to loan demand?

What happens to credit quality?

How exposed is it to capital-market activity?

What sits inside its securities portfolio?

Those questions get much closer to the economics of the business.

Not Every Bank Responds to Rates the Same Way

This is another reason why saying “higher rates are good for banks” doesn't tell me much.

Consider two banks.

Bank A has a huge base of low-cost consumer deposits.

Bank B relies heavily on customers who constantly move their money toward the highest available yield.

If rates rise, Bank A may retain cheap funding for longer.

That can be an enormous advantage.

Now consider:

Bank C earns most of its income from traditional lending.

Bank D earns substantial profits from investment banking and trading.

Again, the effect of higher rates will differ.

This is why deposit franchises can be genuine competitive advantages.

If customers keep large amounts of money with a bank because they trust it, use its payment ecosystem, run their business through it or simply find switching inconvenient, that funding can be incredibly valuable.

Especially when rates rise.