4. How Do Banks Make Money?

Importance of Interest Rates

Clearly, you can see that the interest rate is important to a bank as a primary revenue driver. The interest rate is an amount owed as a percentage of a principal amount (the amount borrowed or deposited). In the short term, the interest rate is set by central banks that regulate the level of interest rates to promote a healthy economy and control inflation.

In the long term, interest rates are set by supply and demand pressures. A high demand for long-term maturity debt instruments will lead to a higher price and lower interest rates. Conversely, a low demand for long-term maturity debt instruments will lead to a lower price and higher interest rates.

Banks benefit by paying depositors a low interest rate and being able to charge lenders a higher interest rate. However, banks need to manage credit risk, which the lenders may potentially default on loans.

In general, banks benefit from an economic environment where interest rates are increasing. It is because banks can lock in fixed-term deposits, paying a lower interest rate while still being able to profit by charging lenders a higher interest rate. Intuitively then, banks will be hurt by an economic environment where interest rates are decreasing, since fixed-term deposits are locked in paying a higher interest rate, while interest rates being charged to lenders are decreasing.

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