Brian Romanchuk — Banks Borrowing Short And Lending Long

Now that there appears to be a chance that the Fed could possibly hike rates by at least a little bit within a few months (maybe), there is increasing interest on what the effects would be on the economy. One area of contention is the effect on the banking system. In my view, you will need a microscope to find the direct effects on banking system profitability (I ignore any macroeconomic feedback from rate hikes, which are an entirely more awkward question). That is not to say that enterprising bank CEO's would not seize upon blaming the Fed for their own failures of leadership. It appears that the belief that the level of interest rates affect bank profitability are based upon inapplicable historical analogies, as well as blurring the distinction between liquidity risk and interest rate risk. 

The academic J.W. Mason did an interesting piece of analysis in "Interest Rates and Bank Spreads." He was responding to an internet debate, which I am not directly addressing. In Mason's article, he crunches the published average bank interest rate charges (both lending and borrowing), and shows that they are consistent with a relatively steady spread regardless of the level of interest rates. Luckily, I do not have to download the data and analyse it myself; he did the work for me. Instead, I want to explain why we should expect this spread behaviour to occur, and an interested reader can then consult his analysis to see that the theory matches observed behaviour.

How banking works.

Bond Economics
Banks Borrowing Short And Lending Long
Brian Romanchuk