Usually when the economy is not doing so well, short term interest rates fall pr
ID: 2452627 • Letter: U
Question
Usually when the economy is not doing so well, short term interest rates fall proportionally more than long term interest rates. As short term interest rates fall, the net interest margin of banks rise. Relate this to the fact that a bigger percentage of the banks liabilities are rate sensitive or variable rate liabilities like demand deposits and money market deposits, while a bigger percentage of their earning assets are fixed rate loans. Usually when the economy is not doing so well, short term interest rates fall proportionally more than long term interest rates. As short term interest rates fall, the net interest margin of banks rise. Relate this to the fact that a bigger percentage of the banks liabilities are rate sensitive or variable rate liabilities like demand deposits and money market deposits, while a bigger percentage of their earning assets are fixed rate loans.Explanation / Answer
Any type of short-term deposit held by a bank that pays a variable rate of interest to the customer can be defined as the interest sensitive bank liablities. Usually the way the economy functions has an impact on the short term interest rates and long term interest rates. Falling interest rates are a sign of a weak economy as this will decrease corporate profits and prevent companies from expanding. Since the pansion will be restricted, there will be less borrowings from the banks. this in turn would reduce lending volumes.
Further lower volumes would mean lower margins.Banks which tend to borrow in short term markets and lend in long term ones, do well when long- term rates are much higher that the short-term equivalents. Borrowing in short-term and lending in long term results in maturity transormation. The loans given by the bank are usually long term. These loans are funded in the shorter term deposits. This would mean that banks would be at a benefit if it has liabilities which are rate sensitivities or variable rate liabilites , and earning assets which are fixed rate loans.
When the economy is not doing well, short term interest rates fall proportionately more than the long term interest rates. Lower interest rates on a sustained basis, impacts the performance of the banks. While the interest rates that banks earn on loans decline, the borrowing cost cannot fall below zero. Hence, banks are not able to use much deposit pricing strategies to boost the margins.
Hence the above statements can be related.
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