Why does one of the strategies for controlling inflation serve the richest and serve the poorest?

This text is taken from the Courrier de l’économie of November 28, 2022. To subscribe, click here.

I cannot understand why the banks are making more and more profit, especially with the rise in interest rates, while businesses and individuals are struggling to meet their mortgage commitments, writes Monik St-Pierre, a reader. Why does one of the strategies for controlling inflation serve the richest and serve the poorest? Why not take this extra money from the banks to invest in the community and help the population?

It is often believed that the higher the interest rates, the more the banks make profits. It is not so simple. Because for a bank it is not so much the level, but rather the difference in rates that matters. Or, simply summarized, the difference between the rate paid on deposits or savings and that collected on loans and other credits granted. This spread or net interest income is highly dependent on the state of competition in the industry.

Certainly, the banks will receive an increased interest rate on their reserves left in the central bank. There may indeed also be a favorable effect during the initial phase of the bullish movement in the form of a widening of this gap. Moreover, empirical observation teaches that this net income generally follows the evolution of rates, with the long-term rate as a reference.

But that said, ultimately, high interest rates will become disadvantageous for banks insofar as they increase the risk of borrower default, which thus forces institutions to increase their provisions for bad debts. And if these high rates cause a recession, financial institutions are among the first to suffer from the contraction of economic activity, the deterioration of credit quality, a reduction in the volume of loans granted and the counter- financial market performance.

The same is true for their personal insurance activities, which invest most of the new premiums received from customers in fixed-income securities benefiting from the rise in rates. But who suffer in return a deterioration of the value of their portfolio in existing fixed income securities.

We see it on the stock market. The Banks component of the S&P/TSX index has fallen more than 8% since the start of the year. This decline was mitigated by a rebound of 4% during the month of October fueled by an observed easing of pressures on the cost of money.

Then, everything depends on the composition of banks’ balance sheets, the fixed rate-variable rate ratio and the average maturity of their assets and liabilities, and the degree of matching of maturities between the two.

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