Interest rates form the basis for valuation models around the world. They are used in almost every industry, country, and geography. Interest rates can also influence corporate and consumer behaviors. For example, depending on the inherent risk of a consumer, credit card rates determine how much an individual must pay on a month basis to the financial institution. Corporations looking to borrow funds to expand their market share must consider the variable interest rates being changed and their ability to service the debt. Even governments must be mindful of the extent of their borrowers and the corresponding impact of interest rates on their ability to services the debt. Due primarily to their importance in key elements of human civilization, interest rates are a closely watched tool by individual investors, general consumers, and corporations. Banks in particular are heavily influenced by the change in interest rates as they operate as financial intermediaries between consumers and business. As a result, they often focus keenly on what interest rates may likely look like in the future and how they will influence the viability of the franchise (Stock, J.H. and Watson, M.W, 2007).
Banks play a vital role in the overall economy. They act as a financial intermediary between savers and borrowers. The often help to match investors (those looking to deploy capital into investments) with business enterprises (those looking to use capital to invest). These transactions ultimately help in delivering a vibrant and health economy. Those businesses that are worthwhile and can enhance the quality of life for others are often met with capital facilitated by the banks. Initial Public Offerings, Secondary Stock Offerings, Bond offerings and so forth help to facilitate these transactions. Likewise, those looking to borrower to finance a home purchase or a car purchase may need additional funds that they otherwise may not have now. As a financial intermediary, banks can help transfer funds from savers (those who do not need to use the money immediately) to borrowers (those who would like to use the funds to purchase products). Again, this helps to provide a fully functioning economy as individual have access to capital they may not have otherwise obtained (Laubach and Williams, 2008).
Although the process of being a financial intermediary appears simple at first, glance it is often complicated by interest rates and beliefs...
The problem of interest rates is compounded by the fact that different purchases, securities, and investments all have varying durations. A car loan can be 5 to 7 years, a mortgage may be 30 years, a certificate of deposit may be for 3 years, and so forth. A bank has the problem of matching the duration of its sources of funds with their respective uses. On occasion, a mismatch of duration has ultimately resulted in financial catastrophe. If left unchecked this asset-lability mismatch cause serious trouble for financial institutions, particular as it relates to interest rates. A typical example relates to banks having large amounts of long-term assets such as mortgages funded in large part by short term liabilities such as deposits or certificates of deposit. In the event of a rise in short term interest rates, these liabilities become more expensive. The interest rates on the longer-term assets, which are often fixed remains unchanged. Another mismatch is when a bank borrows at one rate such a variable rate but then lends money at a different rate that is fixed. Here too, a change in interest, particular is unexpected can have an adverse impact on the bank. In this case, the amount owed to bondholders would increase while fixed payments received remains unchanged. In the 2008 financial crisis, Bear Sterns, a very honored and established investment bank went bankrupt partly because of its inability to adhere to these principles. Here the bank financed itself through deposits, commercial paper and treasury bills. Although each has a very low interest rate, they are needed immediately (See chart 1 below interest rates). Customers for example expect to receive their deposits on demand. It then lent the money out long term to institutions, companies, and institutions, keeping the spread between the interest rates. However, as the financial collapse occurred, it could no longer tap into the short-term financing needed to run its business. The firm soon ran out of cash due to this mismatch of interest rates (Schularick, M, and A M Taylor, 2009).
When looking over the last decade and comparing interest rates between the Federal Funds Rate, Treasury Bills and Treasury Bonds and interesting trend emerges. Under all three circumstances, the interest rate has fallen rather sharply. Due to these historic lows, “Savers” are not earning much on their deposits with the bank. Likewise, banks are not earning as much lending out for the long term as Treasury…
