Banks profit from the gap between deposit and loan rates. When they borrow short-term at high rates but lend long-term at lower rates, spreads collapse. The 2008 crisis happened partly because of this: banks funded long-term mortgages with short-term debt that became expensive when rates rose.
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How do banks work? Now, the business model for all banks, regardless of size, geography, or type, is the same. The goal for banks is to make sure that you earn more from lending money than you have to pay to providers of capital. So let's say you receive £10,000 from a consumer depositing money into your bank. In exchange for their deposit, you pay them 2% annual interest. You then lend £10,000 to a borrower for 5%. This 3% spread enables the bank to make a profit and compensates it for the risk that the borrower will not be able to repay the loan. This model might work for very conservative retail banks. However, many banks want to be able to grow at a much faster pace than their simple customer deposits. So they choose to access the wholesale market, receiving unsecured deposits from other banks, corporate and investors, issuing shorter-term debt instruments to investors and other banks, and issuing secured debt to raise capital. For example, the bundling of a range of assets as collateral for a new debt issuance. This provides a much larger capital base for banks to use in their revenue-generating activities. Now, the base rate for bank funding tends to be linked very closely with central bank interest rates. So when interest rates rise, the cost of bank borrowing increases, and therefore, in order to achieve a positive spread, interest rates on loans to consumers and businesses starts to rise. The danger for banks is that short-term funding can start to become more expensive than long-term lending. The inversion of the yield curve can also invert the bank spread, flipping profit into loss. As banks move from profit to loss, providers of capital start to charge higher risk premiums, compounding negative spreads and bank losses. Now, this was one of the primary causes of the 2008 financial crisis. Following the crisis, a series of important regulations were implemented across the banking industry, regulating the riskier parts of bank activity and ensuring that banks have enough high-quality equity to withstand a future financial crisis. Banks are better regulated and better capitalized than they were before the Great Financial Crisis. However, significant adverse conditions could still compromise a bank's core business model.
