The Impacts of Interest Rates on Banks

By William C. Handorf, Ph.D., Professor of Finance, Banking and Real Estate, George Washington University’s School of Business

Interest rates impact banks in the United States. Almost 96 percent of banking assets earn interest funded by interest-bearing liabilities equivalent to approximately 69 percent of the balance sheet.^{¹Federal Financial Institutions Examination Council (FFIEC): “Summary Ratios for Peer Group 1 (Banks > $100 billion of assets),” Uniform Bank Performance Average Report, 2024.} Consequently, interest rates affect interest income, interest expense, the resultant net interest margin (NIM) and profitability. Interest rates reflect monetary policy, fiscal policy, inflation and the business cycle. Loan demand and repayment vary with interest rates, as do economic growth or retraction. Banks direct special attention to interest rates when developing business plans.

Interest rates differ by maturity, credit risk and currency, among other factors. The term structure of interest rates provides a convenient source of information by which to assess economic trends. The term structure is illustrated by a U.S. Treasury yield curve that measures yield on the vertical axis and maturity on the horizontal axis. The shape of the yield curve has been found useful in predicting future interest rates and the probability of a recession.

An upward-sloping yield curve indicates that the market projects higher interest rates, while an inverted yield curve indicates rates will decline. The forecast is based on the expectations theory, whereby long-term interest rates reflect the serial sequence of short-term interest rates. To illustrate, a two-year rate is based on the current one-year rate and an unknown one-year rate in one year. As of early 2025, one-year U.S. Treasuries yield 4.22 percent, and two-year Treasuries are priced to yield 4.30 percent. The yield curve is modestly upward-sloping.

(1 + Two-year Yield)² = (1 + One-year Yield)¹ (1 + One-year Forward Yield)¹

(1.0430)² = (1.0422)¹(1 + Forward Yield)¹

The forward yield equals 4.38 percent.

The yield curve provides a method of forecasting a wide range of interest rates.^{²The Financial Review: “Accuracy of International Interest Rate Forecasts,” Thomas F. Gosnell and Robert W. Kolb, August 1997, Volume 32, Issue 3, Pages 431-448.} The accuracy of the forward rate derived declines when forecasting more than several years in the future. The forward rate derived is biased high. The actual rate subsequently observed is typically lower than the forward rate calculated due to the existence of a liquidity premium. A two-year security retains a higher duration than a one-year instrument, and its price is thereby more volatile. Many banks use expectations as a base to develop projections of future operations.

The yield curve has also been found useful in predicting the likelihood of a recession. An upward-sloping curve is consistent with higher interest rates and a strong economy when the central bank focuses on curbing inflationary pressures. An inverted curve suggests rates will decline given monetary accommodation to counter high unemployment in a recession. Some models focus on the spread between 10-year and 3-month rates, while others use the spread between 10-year and 2-year rates.^{³The Federal Reserve Bank of New York/Current Issues in Economics and Finance: “The Yield Curve as a Predictor of U.S. Recessions,” Arturo Estrella and Frederic S. Mishkin, June 1996, Volume 2, Number 7, Pages 1-6.} Any model can produce false forecasts.

This article provides a historical perspective of interest rates’ impacts on bank operations.

Public policy

Both monetary policy and fiscal policy influence interest rates. The central bank changes interest rates according to its dual mandate. A recent press release from the Federal Open Market Committee (FOMC) illustrates the monetary dilemma.^{⁴Board of Governors of the Federal Reserve System/Federal Open Market Committee (FOMC): Press Release, November 7, 2024, Pages 1-4.}

The Committee seeks to achieve maximum employment and inflation at the rate of 2 percent over the longer run. The Committee judges that the risks to achieving its employment and inflation goals are roughly in balance. The economic outlook is uncertain, and the Committee is attentive to the risks to both sides of its dual mandate.

The Federal Open Market Committee increases the trading range of federal funds to control inflation and reduces short-term money-market interest rates to foster borrowing, stimulate investment and boost employment. The central bank, similar to any forecasting model, is not infallible.

Fiscal policy reflects governmental decisions regarding taxation and spending. The federal government approved a diverse array of aid programs to recover from the recent pandemic (e.g., the Coronavirus Aid, Relief, and Economic Security Act (CARES Act), the Paycheck Protection Program (PPP), et cetera). The legislation cost approximately $5 trillion.^{⁵The New York Times: “Where $5 Trillion in Pandemic Stimulus Money Went,” Alicia Parlapiano, Deborah B. Solomon, Madeleine Ngo and Stacy Cowley, March 11, 2022.} Gross federal debt ballooned from $21 trillion as of 2018 to $33 trillion by 2023.^{⁶U.S. Department of Treasury: “Fiscal Debt,” Fiscal Data, 2024.} The immense increase in debt has resulted in a surge of public expenditures required to pay the interest. The Federal Reserve purchased a significant share of the newly issued securities as part of its quantitative-easing program adopted during the pandemic. Between 2020 and 2022, the portfolio of securities owned by the central bank surged from $4 trillion to more than $8 trillion.^{⁷Federal Reserve Bank of St. Louis/Federal Reserve Economic Data (FRED): “Securities Held Outright by the Federal Reserve,” 2024.} The combined massive fiscal spending and exceptionally easy monetary conditions fueled the inflation that Federal Reserve officials initially dismissed as “transitory”.

Impacts of interest rates

We reviewed a wide variety of financial metrics on an annual basis between 2005 and 2023 to assess the impacts of interest rates on banks. This period includes the Great Recession of 2007-09 and the more recent health crisis between 2020 and 2022. Financial and economic data are derived from the Federal Reserve Economic Data (FRED) compiled by the Federal Reserve Bank of St. Louis. Bank data is from the Uniform Bank Performance Reports (UBPRs) compiled by the Federal Financial Institutions Examination Council (FFIEC). Table 1 shows the average for each metric, along with the correlation of the variable with 90-day Treasury bills and 10-year Treasury notes. Correlation analysis provides a measure of the relative, not absolute, relationship between two variables and does not suggest causality or economic consequences. The correlation coefficient between two variables can range from + 1.00, or perfect positive correlation, to – 1.00, or perfect inverse correlation.

Interest rates: Three-month Treasury bills (i.e., the money market) averaged 1.45 percent during the period sampled and ranged from a low of almost zero during the Great Recession and the pandemic to more than 5.25 percent as the central bank tried to control inflation that had not proven transitory. Ten-year Treasury notes (i.e., the capital market) averaged 2.84 percent and ranged between 4.80 percent in 2006 and 0.89 percent in 2020. The yield curve, on average, was upward-sloping, reflecting the existence of a liquidity premium.
Bank interest income: US banks, on average, earned 4.55 percent on assets, ranging between 6.67 percent and 3.39 percent. The correlation between interest income-to-assets and the money market was 64.19 percent, which is significant at the one-percent confidence level. The correlation between interest income and the capital market was 86.06 percent, which is also highly significant. There is a very low likelihood that the positive relationship is by chance.
Bank interest expense: US banks paid an average of 1.03 percent on liabilities, ranging between 2.85 percent and 0.30 percent. The correlation between interest expense-to-assets and the money market was 66.10 percent, which is significant at the one-percent level. The correlation between interest expense and the capital market was 84.97 percent, which is highly significant. The high correlation between interest income and expense with U.S. Treasury interest rates is expected given that governmental rates affect the prime, the Secured Overnight Financing Rate (SOFR), borrowed money and brokered certificates of deposit (CDs).
Bank net interest margin: The net interest margin (NIM) earned by banks averaged 3.51 percent and ranged between 3.96 percent and 3.08 percent. The variability of the margin is much narrower than interest income or expense, because income and expense change in the same direction. The correlation between the net interest margin-to-assets and the money market was 45.80 percent, which is significant at the 5-percent level of confidence. The correlation between the margin and the capital market was 71.66 percent, which is significant at the one-percent level. The net interest margin correlates with interest rates given the very positive earning power ratio (interest-earning assets divided by interest-bearing liabilities) enjoyed by banks of 1.37. The majority of the nation’s 4,600 banks have far more assets earning interest than are offset by liabilities bearing interest.
Return on assets: Return on assets (ROA) averaged 0.87 percent during the period sampled and ranged between 1.10 percent and 0.19 percent. The correlation between the common measure of profitability and the money market was 40.04 percent, which is significant at the 5-percent level. There was no statistical significance between earnings and the capital market. Although non-interest income and non-interest expenses also affect bank profits, the net interest margin is an important component. Bank profits are especially sensitive to shifts in the provision for loan losses, which vary with the business cycle.
Real gross domestic product (GDP): The inflation-adjusted change in the output of goods and services averaged 2.06 percent during the tumultuous period sampled. GDP increased by as much as 6.1 percent during the year following the onset of COVID-19 and declined by 2.6 percent during the Great Recession. Although the correlations between GDP and money-market and capital-market rates were both positive, neither relationship was significant. By contrast, the return on assets earned by banks was highly and positively correlated with the output of goods and services. Loan demand and repayment reflect economic growth or contraction.
Unemployment: The average annual unemployment rate during the sample period was 5.91 percent and ranged from 9.6 percent to 3.6 percent. The correlation between individuals seeking work but unable to obtain employment and the money-market rate was -61.61 percent, which is significant at the one-percent level. Employment is one of the pillars of the dual mandate assigned to the central bank. The correlation between the unemployment rate and the capital market was also negative but not significant.
Inflation: The average annual percentage change in consumer prices was 2.56 percent and ranged between 8.0 percent following the pandemic to falling 0.3 percent during the Great Recession. The correlation between inflation and the money market was 41.60 percent, which is significant at the five-percent level. While the central bank is equally concerned with price changes and employment, its focus is on projected Projected inflation can be estimated by subtracting the yield on Treasury Inflation Protected Securities (TIPS) from Treasury notes with the same maturity. As of 2025, annual inflation is projected to be 2.40 percent over the next five years, given that five-year notes yield 4.45 percent and TIPS yield 2.05 percent. The correlation between inflation and the capital market was also positive but not statistically significant.
Fiscal deficit: The fiscal deficit-to-GDP averaged 5.45 percent as the federal government attempted to offset the economic contractions following both the housing bust and the later health crisis. The deficit ranged from 14.67 percent as COVID-19 rapidly spread to 1.11 percent early in the sample period. The correlation between fiscal deficits compared to GDP and the money market was 42.69 percent, which is significant at the five-percent level, and 53.70 percent with the capital market, which is significant at the one-percent level.

Table 1

Interest Rate Impact on Bank Operations and Economic Indicators

Metric	Average	Correlation T-bill	Correlation T-Note
90-day T-bill	1.45%	N/A	N/A
10-year T-note	2.84%	N/A	N/A
Interest Income	4.55%	64.19%*	86.06%*
Interest Expense	1.03%	66.10%*	84.97%*
Net Interest Margin	3.51%	45.80%**	71.66%*
Return on Assets	0.87%	40.04%**	-11.98%
Real GDP	2.06%	19.30%	6.59%
Unemployment	5.91%	-61.61%*	-23.34%
Inflation	2.56%	41.60%**	26.55%
Deficit/GDP	-5.45%	42.69%**	53.70%*

Statistical Significance: * 1% Confidence Level, ** 5% Confidence Level

The concluding section more fully explores the strategic issues related to fiscal affairs, growth and interest rates.

Projected fiscal policy

The Congressional Budget Office (CBO) has projected that gross federal debt outstanding will increase from $35 trillion in 2024 to $54 trillion by 2034.^{⁸Congressional Budget Office (CBO): “The Budget and Economic Outlook: 2024 to 2034,” February 7, 2024, Pages 1-94.} The public holds the majority of this debt, comprising all the obligations the federal government owes to individuals, businesses, banks and various governmental entities. Public debt comprises approximately 80 percent of gross debt outstanding and does not include intragovernmental debt (e.g., securities owned by the Social Security Trust Fund and government-sponsored retirement programs). Debt held by the public is projected to increase from $28 trillion in 2024 to $48 trillion 10 years hence. Public debt as a percentage of GDP is expected to increase from 99 percent in 2024 to 116 percent 10 years later. The U.S. Government Accountability Office (GAO) has indicated that “the federal government faces an unsustainable long-term fiscal path that poses serious economic, security and social challenges if not addressed.”^{⁹U.S. Government Accountability Office (GAO): “The Nation’s Fiscal Health: Road Map Needed to Address Projected Unsustainable Debt,” Gene L. Dodaro, February 15, 2024, Annual Report to Congress, Pages 1-48.}

There is controversy regarding debt and growth. Reinhart and Rogoff found, “First, the relationship between government debt and growth is weak for debt/GDP ratios below a threshold of 90 percent. Above 90 percent, median growth rates fall by one percent, and average growth falls considerably more.”^{¹⁰National Bureau of Economic Research (NBER): “Growth in a Time of Debt,” Carmen M. Reinhart and Kenneth S. Rogoff, January 2010, NBER Working Paper No. 15639, Pages 1-25.} By contrast, Panizza and Presbitero found, “While many papers have found a negative correlation between debt and growth, our reading of the empirical literature is that there is no paper that can make a causal relationship going from debt to economic growth.”^{¹¹Swiss Journal of Economics and Statistics: “Public debt and economic growth in advanced economies: A survey,” Ugo Panizza and Andrea F. Presbitero, December 28, 2013, Volume 149, Pages 175-204.}

The US will offer a laboratory over the next decade to determine how the economy and the dollar’s status as a world reserve currency will be impacted by high debt. The additional demand for funds by the federal government will impact interest rates. Laubach pointed out, “The estimated effects of government deficits and debt on interest rates are statistically significant and economically relevant: about 25 basis points per percentage point increase in the projected deficit/GDP and 3 to 4 basis points for the debt/GDP ratio.”^{¹²Journal of the European Economic Association: “New Evidence on the Interest Rate Effects of Budget Deficits and Debt,” Thomas Laubach, June 1, 2009, Volume 7, Issue 4, Pages 858-885.}

Summary

Interest rates affect bank operations as well as loan demand and repayment. The structure of interest rates allows banks to project interest rates, the economy and inflation. The Federal Reserve will continue to adjust short-term money-market rates via the federal funds target rate to achieve its dual mandate. However, long-term capital-market rates will remain elevated, given an unsustainable fiscal policy.

References

¹Federal Financial Institutions Examination Council (FFIEC): “Summary Ratios for Peer Group 1 (Banks > $100 billion of assets),” Uniform Bank Performance Average Report, 2024.

² The Financial Review: “Accuracy of International Interest Rate Forecasts,” Thomas F. Gosnell and Robert W. Kolb, August 1997, Volume 32, Issue 3, Pages 431-448.

³The Federal Reserve Bank of New York/Current Issues in Economics and Finance: “The Yield Curve as a Predictor of U.S. Recessions,” Arturo Estrella and Frederic S. Mishkin, June 1996, Volume 2, Number 7, Pages 1-6.

⁴Board of Governors of the Federal Reserve System/Federal Open Market Committee (FOMC): Press Release, November 7, 2024, Pages 1-4.

⁵The New York Times: “Where $5 Trillion in Pandemic Stimulus Money Went,” Alicia Parlapiano, Deborah B. Solomon, Madeleine Ngo and Stacy Cowley, March 11, 2022.

⁶U.S. Department of Treasury: “Fiscal Debt,” Fiscal Data, 2024.

⁷Federal Reserve Bank of St. Louis/Federal Reserve Economic Data (FRED): “Securities Held Outright by the Federal Reserve,” 2024.

⁸Congressional Budget Office (CBO): “The Budget and Economic Outlook: 2024 to 2034,” February 7, 2024, Pages 1-94. (https://www.cbo.gov/publication/59946)

⁹U.S. Government Accountability Office (GAO): “The Nation’s Fiscal Health: Road Map Needed to Address Projected Unsustainable Debt,” Gene L. Dodaro, February 15, 2024, Annual Report to Congress, Pages 1-48.

¹⁰ National Bureau of Economic Research (NBER): “Growth in a Time of Debt,” Carmen M. Reinhart and Kenneth S. Rogoff, January 2010, NBER Working Paper No. 15639, Pages 1-25.

¹¹Swiss Journal of Economics and Statistics: “Public debt and economic growth in advanced economies: A survey,” Ugo Panizza and Andrea F. Presbitero, December 28, 2013, Volume 149, Pages 175-204.

¹²Journal of the European Economic Association: “New Evidence on the Interest Rate Effects of Budget Deficits and Debt,” Thomas Laubach, June 1, 2009, Volume 7, Issue 4, Pages 858-885.

ABOUT THE AUTHOR

William C. Handorf, Ph.D., is a Professor of Finance, Banking and Real Estate at the George Washington University School of Business. Over the course of his almost 60 years in the banking industry and 50 years as an academic, he recently completed his 17-year term as a Director, Vice-Chair and Committee Chair of a U.S. Securities and Exchange Commission (SEC)-registered bank in Atlanta, Georgia. Earlier, he served as a Director and Chair of the Federal Reserve Bank of Richmond’s Baltimore branch.

Go to top