Question

Are higher or lower interest rates beneficial to institutions that borrow short & lend long? Explain with the help of an example.

Answer 1

Yes, Both the Higher and the Lower interest rates are beneficial to institutions that borrow short and lend long.
First, Let us understand the meaning of borrowing short and lending long in case of the insitutions, Borrowing short is the money that the Institutions raises from its customers in the form of deposits paying a very low interest rate which the customers can withdraw from the bank anytime they need it. Lending long simply means the money that the bank lend for the long term to the borrowers (i.e. mortgage) from the pool of the deposits that it raised in form of deposits. The difference between the interest rate that the Institution offer to the customer to deposit and the borrower to whom it lends money is the source of income for it called the Net Interest Margin. With the increase/decrease in the interest rate the Institutions make more money as the interest spread increase between the interest they get lending loan and the interest they offer to the customers to keep their money with it.

Example for the same is:
Now with the increase in the interest rates the Bank will be directly able to increase their earnings as now they can lend money on higher interest rate assuming that the bank would keep raising money on lower interest rates in the form of deposits from the customers and the borrower wont default the money that was lent to them.

Similarly, taking the case when the interest rate is low bank can now reduce the interest rate that they were offering to create deposits from customers and can lend the money to the borrowers at a higher interest rate assuming that the bank will keep on raising money at lower interest rate and lending the same money at higher interest rate without the risk of default from the borrower to earn the interest spread.