Can banks ride the wave of rate rises?

Low rates mean that people can borrow more easily, as money is cheap; it is also relatively rare for borrowers to get into trouble, as their debt service costs are low.

High interest rates put these trends into reverse. As Ben Hunt argues in this week’s cover story on page 24, they increase the risk of borrowing and the level of bad debt. When high interest rates follow a period of low rates, the problems can be more severe as household debt tends to rise substantially when rates are low.

This has certainly happened in the UK, with borrowers taking out ever bigger mortgages to pay for houses that are increasing in price. A significant rise in rates can easily turn a mortgage, or another form of debt, from a manageable burden into an unmanageable one. Repaying a mortgage of, say, £100,000 may be affordable at low interest rates, but not at higher ones.

One important caveat needs to be added to this general point. Banks can increase their net interest income – the difference between the rate at which they lend and the savings rate they pay out – to boost their profitability while interest rates are changing. For example, when base rates are rising they can – and frequently do – increase mortgage rates more rapidly than they increase savings rates. As a result, their net income enjoys a temporary boost. The risk with such a strategy, of course, is that savers can decide to take their money elsewhere.

It is also important to recognise that the strategy of increasing net interest income can work only for a limited time. Once interest rates stabilise, it is no longer possible to benefit from changing rates.

Rising rates do not necessarily spell disaster for the banks. No doubt the better-managed ones will have anticipated the impact of higher interest rates. But they could hit overall bank profitability in the period ahead.

Over the past decade, financials funds have often proved a good longer-term investment and investors have done well out of specialist vehicles in this area. However, the expected period of higher interest rates could make life more difficult than it has been in the recent past.