How Interest Rate Shifts Shape the Banking Sector

By Carmen Foo

Interest rates represent one of the most fundamental forces governing the financial health of banks. Unlike simple economic actors that suffer uniformly when borrowing becomes expensive, banks actually benefit substantially when interest rates rise, but this advantage comes with a significant expiration date and substantial complexities that merit careful examination.

The Mechanics of Bank Profitability

To understand how interest rates reshape banking, one must first grasp the business model at banking's core. Banks earn money by accepting deposits— paying interest to savers— and lending that money at higher interest rates, with the difference constituting their net interest margin. This gap typically widens when the Bank of England (BoE) raises rates. The reason is structural: banks can raise lending rates almost immediately on new loans and variable-rate mortgages, but banks may deliberately pass on rate increases to depositors slowly to preserve their profitability. This deposit-rate behaviour has been particularly pronounced in the UK, where deposit churn has remained a persistent challenge despite the central bank cutting rates throughout 2025.​

Consequently, higher interest rates tend to expand bank profitability in the short to medium term. UK banks have exemplified this dynamic, with NatWest reporting a net interest margin of 2.64% (up 5 basis points year-on-year despite falling rates) and Lloyds maintaining margins at 3.04% even as the BoE reduced its base rate to 4%.​

However, this profitability windfall is temporary. The structural hedge effect, where banks lock in proceeds from maturing lower-yielding bonds purchased during the pandemic's ultra-low interest rate period, provides a one-time boost to profitability as these securities mature and proceeds are reinvested at higher yields. HSBC's UK operations recorded a higher net interest income of £4,203 million in the first half of 2025, driven explicitly by repricing of the structural hedge and balance sheet growth,  partly offset by base rate reductions and mortgage pricing competition.​ As interest rates continue to decline, banks compete for deposits at higher rates and face compression from both directions.​

Rate-Cutting: Benefits and Headwinds

As of late 2025, the BoE has cut rates from their 5.25% peak, bringing the base rate to 4%. The Monetary Policy Committee (MPC) voted to maintain rates at this level in September, though market expectations suggest further cuts may follow. This transition introduces a paradox for banks: falling rates compress net interest margins but paradoxically stimulate loan demand and improve credit quality.​

Lower rates reduce debt-servicing burdens for borrowers, meaning fewer loan defaults and lower provisions for credit losses. As UK rates have fallen, mortgage approvals have climbed from the doldrums of 2023-2024, reaching 65,944 in September 2025— the highest monthly level since December 2024. UK mortgage lending growth is forecast to rise to 3.1% (net) in 2025, more than double from 1.5% in 2024.​

Even as the BoE has reduced its base rate, depositors have shifted away from low-interest current accounts toward higher-yielding savings products. This "deposit churn" means banks must offer more attractive savings rates to retain deposits, thereby compressing net interest income precisely when asset margins are also under pressure from falling loan rates. Lloyds explicitly noted continued "deposit churn headwinds" in its first-half 2025 results, though it partially offset these with structural hedge contributions and balance sheet growth. NatWest's net interest margin improved to 2.64%, up 5 basis points year-on-year, despite the challenging rate environment. This performance underscores that while the overall trend in interest rates is downward, skilled balance sheet management and timely deposit repricing can still generate respectable returns.​

The Path Ahead

Market speculation intensified in late October 2025 regarding another BoE rate cut, with major institutions including Barclays and Goldman Sachs forecasting a November reduction to 3.75%. Analysis by the Financial Times suggests the MPC expects rates to decline gradually to approximately 3.5% by year-end, with quarterly reductions providing a managed path downward.​

For UK banks, further rate cuts present a strategic inflection. While lower rates compress margins and reduce the benefit of the structural hedge, they simultaneously stimulate lending demand and improve credit quality, potentially offsetting margin pressure with volume and lower provisions. The mortgage market, in particular, may see renewed activity if rates fall decisively below 4%, with major lenders already having cut selected products below 4% for prime borrowers.​

In conclusion, the UK banking sector's journey from 5.25% rates to the anticipated 3.5%-3.75% environment over the next 18 months will not be smooth. Banks must operate on the understanding that  exceptional returns of the high-rate cycle are unlikely to persist. For UK savers and borrowers, this transition offers mixed signals: falling rates will eventually translate into cheaper mortgages and loans, yet heightened competition for deposits may constrain savings rate improvements.