Ignoring the issue of increased interest on loans and higher interest costs for deposits, we’ll focus on the affect a rise in interest rates will have on a bank’s portfolio.

As rates rise, a bank’s assets will roll over into new, higher interest earning assets at different speeds.  The shorter the terms of its assets, the more quickly it will be able to profit from higher rates.  Higher rates will also affect its portfolio of marketable securities (stocks, bonds), with longer term securities decreasing in value more as rates rise.  A bank with high cash reserves, on the other hand, will benefit as it rolls cash into interest earning assets as rates rise.

Bank liabilities are largely made up of CDs, long term borrowing subordinated to deposits, Fed fund borrowings, and retail deposits.  These liabilities become more attractive as rates rise.

Overall, a bank will benefit from a rate increase if it has borrowed long, with locked-in low interest costs, and lent short, allowing it to roll short term, low interest paying loans into higher interest loans as rates rise, funded by its low interest deposits of longer duration.  But how many bank portfolios are structured this way?  The Fed is worried about this.

But, according to Morgan Stanley and as reported by Bob Murphy, the Fed has its own problems. It could have negative equity if an interest rate rise decreases the value of its bond portfolio.  This makes Fed “tapering” very dangerous to its own portfolio and probably unlikely.  It needs to keep interest rates low and its portfolio strong with continuing asset purchases (QE), but those asset purchases continue to skew markets and capital structures and make inflation more likely.  Dangerous territory.