Breaking Out the Financials

The old common rule of thumb was that falling interest rates are good for bank and rising equity prices are good for the insurance companies. At first blush, this makes some sense. Banks tend to borrow short-term (deposits and CDs) and lend long-term (mortgages, corporate term-loans, etc.), so many believe that falling rates help a bank's bottom line. As interest rates fall, their cost of funding falls but they have locked in rates for anywhere from 2 to 10 years. But this is a bit of a fallacy as banks hedge their interest rate risk. So they lose money on their hedges when rates fall. By the same token, they make money on their hedges when rates rise which offsets losses on their term loans. What really matters is the spread between their cost of borrowing and the revenue generated on their loan portfolio. A bank's hedging activity is designed to lock in that spread to insulate it from fluctuations in the general level of interest rates.

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