As interest rate hikes continue to make headlines, the impact they had on banks globally for almost a year has become a topic of concern, especially after the fall of four US lenders and one major European lender.  

While it was widely expected that central banks would pause rate hikes amid the deepening global banking crisis, the European Central Bank last week hiked key rates by 50 basis points and the US Federal Reserve went for a 25 basis point increase on Wednesday. 

Although the Fed signalled that it could pause interest rates soon if inflation comes down, fears of a possible banking crisis continue to grow. 

But why are banks under pressure? Let's find out. 

Impact on Net interest income 

For banks, interest rates are a crucial factor in determining their profitability and overall business performance. 

One of the primary ways in which interest rate hikes impact banks is through their net interest income (NII), which generates a significant portion of their revenue. 

NII is basically the difference between the interest earned on loans and investments, and the interest paid on deposits and other borrowings. 

So, when interest rates rise, the interest paid on deposits and other borrowings also increases, which can compress the net interest margin and reduce profitability.

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Loan demand takes a hit

Interest rate hikes by central banks also impact loan demand of private and public lenders. Higher interest rates can make borrowing more expensive, leading to a decline in loan demand, particularly for home loans and other long-term loans. 

This can negatively impact banks that rely heavily on their loan portfolio for revenue. This is exactly the problem that several mid-sized banks are facing in the US. These banks typically have a less diversified portfolio and heavily rely on their lending business. 

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Other risks 

Interest rate hikes can also impact the value of banks' investments in securities, such as bonds and treasury bills. This is because when interest rates rise, the value of these investments can decline, leading to lower investment income.

Silicon Valley Bank in the US suffered huge losses in bond investments due to rising interest rates. As interest rates rose, the value of the bank's investment in long-term bonds declined sharply, leading to huge losses on its balance sheet. 

Another significant impact of interest rate hikes on banks is on their capital adequacy. 

It may be noted that capital adequacy is a measure of a bank's ability to absorb losses, and interest rate hikes can lead to an increase in loan defaults, which can impact a bank's capital adequacy ratio.

How banks can stay safe 

While a prolonged period of interest rate hikes can make the environment extremely challenging for banks, there are ways to stay protected.

Banks can shield themselves from risks by diversifying their revenue streams, helping them manage their balance sheets more efficiently. 

For instance, banks can look at increasing their fee-based income by offering services like wealth management, insurance and advisory services. They can also optimise their balance sheet by adjusting their asset-liability mix and managing their liquidity and capital position.

Last but not least, banks need to remain vigilant at all times to actively take measures and stay protected in the event of a crisis. 

2023-03-24T04:22:00Z dg43tfdfdgfd