How do changes in interest rates affect the profitability of the bank and citizens and businesses?

The banking industry includes not only commercial banks (as we have them in Albania), but mainly investment banks, microcredit financial institutions (not banks) and pension and insurance companies[1].

All banks have large cash holdings. They hold a small amount of cash to ensure liquidity and meet the criteria of guaranteeing savings deposits as well as other legal reserves that are required by accounting standards.

The rest is invested either in treasury bonds, securities, or in direct investments or in partnerships with other partners in the market. Even the very low interest rates that Treasury bills give are in any case greater than the interest that banks pay to their customers. This is the wave of cash that originates from the state treasury and flows continuously through the banking system.

While partnerships in other investment funds, or in direct investments are part of a business relationship, which the bank chooses to do to maximize its profit[2].

Part of the bank’s money is also invested in loans to businesses and consumers.

It is similar to how an increase in the price of bread, where producers benefit directly from the increase in its price. So they make more money for the same volume of spending.

The same financial logic occurs when interest rates rise. Higher interest rates increase the return on their investments.

In this case, profitability in the banking sector increases. Profits increase mainly because banks can earn a higher yield[3] for any money they invest or lend to individuals/businesses. All this increase in profit comes from new lending/loan contracts, as any change in the value of the loan is based on the contract between the parties and cannot be changed unilaterally by the bank.

Notice! In any case when a contract change is required, or you find that you have a change in the payment of the loan installment, you must follow the communication steps for clarification from the counter in writing and then also a complaint to the Central Bank.

Bank profit is the difference between the interest they pay to their depositors and the profit they receive through investment/lending. Banks make money by accepting cash deposits from their customers in exchange for interest payments and then investing or lending that money to various customers who meet the criteria to borrow from the bank[4].

Let `s Take An Example

Let’s assume that a bank has 1 billion Euros on deposit. The bank pays its customers an annual percentage of 1% interest, but the bank earns 2% of that money by investing it in treasury bills.

So, the bank is earning 20 million Euros from its customers’ accounts, but it is returning only 10 million Euros to its customers, who have deposited money in the bank.

If the central bank increases the interest rate by 1%, then the Treasury bond rate will increase from 2% to 3%. The bank will then earn 30 million Euros from customer accounts. The payment for customers who have deposited money will still be 10 million Euros.

Meanwhile, the bank may be forced to increase the interest rates it pays on deposits if the higher interest rates continue for many periods. But, this does not happen automatically. It is necessary that the vast majority of its customers go in search of a better return for their savings and this requires a dialogue that should also be supported by the central bank.

Interest rate hikes tend to occur when economic growth is strong. Businesses in these periods expand and consumers spend more. This means a greater demand for credit.

As interest rates rise, the profitability of loans increases, as there is a greater spread between the Treasury bill rate the bank earns on its short-term loans and the interest rate it pays its customers.

In fact, long-term rates tend to rise faster than short-term rates.

When interest rates rise, the new bonds that are issued must have a higher rate of return in order to be attractive to buyers.

However, holders of older bonds are stuck with their lower rates of return. In the secondary market where the bonds are resold, their value will decrease to compensate for the lower return. An investor who holds bonds in an investment portfolio does not lose money, but loses the opportunity to invest in bonds with a higher yield.

Higher interest rates are good for the Lek. When short-term interest rates change, the change occurs across all other types of loans, including loans represented by treasury bonds and all other investments denominated in Leka.

When the rates are high compared to those of other countries, money can come from foreign investments and this can cause the Lek to increase in value against other currencies. In fact, the interest rate in the last two years in Albania has not been higher than in other countries (regional or EU)

[1] https://www.investopedia.com/ask/answers/041015/how-do-interest-rate-changes-affect-profitability-banking-sector.asp

[2] https://www.thebanker.com/How-are-rising-interest-rates-affecting-banks-1689593378

[3] Recovery of expenditure or investment

[4] https://www.esm.europa.eu/blog/are-banks-profits-here-stay