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12 02 2015 | by Victor Xing | Capital Markets

Do banks benefit from higher interest rates?

At higher interest rates, banks would have more options to generate returns while taking less risk (Federal Reserve’s ultra-low rates have pushed financial market participants into riskier behaviors such as taking higher interest rate risk, credit risk, etc):

  1. Banks can deploy capital in long carry roll-down strategies – these strategies work better under higher interest rates
  2. At higher rates, banks take less interest rate risk on bonds held in its portfolios thanks to conventional (bullet) bond’s positive convexity characteristic.  Another more intuitive way to think about this: the higher a bond’s coupon, the more “buffer” an investor has to offset losses from rising rates
    Higher interest rates - lower duration
  3. Under financial repression (and lower volatility), many financial institutions such as banks had increased their bond holdings’ aggregate duration (taking more interest rate risk), making them more susceptible to VaR shock.  The most recent VaR shock event was in April 2015 (banks and financial institutions loaded up on low volatility, low interest rate German sovereign bonds, and many had to capitulate when volatility rose)
  4. Banks can achieve higher returns with their traditional lending operations under higher interest rates

 

Original Quora article

Next article12 01 2015 | by Victor Xing | Economics

What were historic drivers for dollar valuation?