By Andreas Charalambous and Omiros Pissarides

The prolonged period of rising inflation over the past year and a half has pushed major Central Banks to successive interest rate hikes. Specifically, base rates in the US have risen sharply, from 0.25 to 5 per cent, while interest rates in the EU have jumped from -0.5 to 3.5 per cent over the last twelve months. Today’s article attempts to summarise the key implications for commercial banks.

Empirically, periods of high interest rates, such as the one we are experiencing currently, offer banks an opportunity for improved profitability, due to better returns on their deposits with central banks, as well as the widened gap between deposit and lending rates.

At the same time, however, higher interest rates lead to a decrease in the value of investment securities that banks hold as assets. During the pandemic, when deposits were plentiful and loan demand limited, many banks significantly increased their bond portfolios. For some banks, the losses due to the increase in interest rates were simply of an accounting nature. However, a significant number of banks faced real losses, especially in cases where they were forced to sell securities for the purpose of covering liquidity needs, like Silicon Valley Bank. Losses were particularly large in cases of liquidation of long-dated securities, which are disproportionately affected in periods of increased interest rates.

In general, banks can classify their securities into two categories: held-to-maturity and available-for-sale. The difference between the amortised cost of the securities held-to-maturity and their current fair value is recorded in accumulated other income which is added/subtracted from equity, thereby affecting the capital adequacy ratio that is a key indicator for the financial health of a bank. In the US, due to the aggressive earnings strategy adopted during the period of low interest rates manifested, among other things, in the accumulation of long-term bonds, the number of banks whose capital adequacy ratio to assets was affected and fell below 5 per cent, increased significantly in 2022.

An additional consequence of the recorded sizeable unrealised losses for a number of banks, includes restrictions on borrowing capacity, but also a reduction in the valuations of the affected institutions, thus leading to additional capital requirements, either for regulatory requirements or to engage in M&A activities.

Another essential parameter concerns private consumption and investment, which are negatively affected by higher interest rates, both in terms of consumption/investment intention, as well as repayment capacity.

Ultimately, rising interest rates have created both opportunities and challenges for banks. Any bank, regardless of strength, should carefully analyse its existing capital and liquidity planning for possible adjustments based on evolving data.

Andreas Charalambous and Omiros Pissarides are economists