RDP 2023-05: The Impact of Interest Rates on Bank Profitability: A Retrospective Assessment Using New Cross-country Bank-level Data 4. Channels of Monetary Policy to Bank Profitability

A bank's overall profitability, as measured by its ROA, can be decomposed simplistically according to the identity below – see Brassil (2022) for a more complete decomposition:

RO A t ( NonI I t +NI M t LL P t ),whereNI M t i A A i L L A =( i A i L )+ i L ( E A )

In this identity, ROA, Non-II, NIM and LLP are defined as a share of assets. The average interest rates on banks' interest-bearing assets and liabilities are iA and iL respectively, and A, L, and E are the values of banks' assets, liabilities and equity. This decomposition motivates us to examine not only the association between interest rates and ROA, but also the association with NIMs, Non-II and LLPs. This allows us to unpack the channels through which changes in interest rates and the slope of the yield curve affect overall profitability. These channels are considered in detail below.

NIMs: As interest rates fall a larger share of bank deposits pay very low interest rates. This can squeeze NIMs because as rates fall, deposits that already receive zero or very low interest rates have not been repriced lower in line with lending rates or the return on liquid assets. This is especially true if market rates become negative, as banks may be unable to adjust deposit rates. There is also a mechanical association between interest rates and banks' NIMs. This occurs because a share of banks' funding is from equity, which does not bear interest. This limits the extent to which a reduction in interest rates flows through to lower funding costs and mechanically reduces NIMs. To see this, note that in the identity above, even with constant spreads, the NIM falls as the level of interest rates declines. The slope of the yield curve also matters, as banks' loans and other assets typically have longer durations than their liabilities.

The impact of policy rates on profits is also likely to vary by bank size. Large banks have more complex business models and more diverse sources of income which may make them more nimble in shoring up profitability as NIMs decline. Larger banks also tend to rely less on deposit funding and more on market-based sources of funding, and so their NIMs could be expected to compress less when interest rates decline because of the effective lower bound on deposit rates. This hypothesis is consistent with the idea that larger banks with global operations are more insulated from changes in monetary policy (Cetorelli and Goldberg 2012).

Non-II: The reduction in NIMs could be offset by changes in Non-II. When interest rates fall, banks gain from the revaluation of longer-term assets given their role in maturity transformation and the associated positive duration gap between assets and liabilities. Banks can also offset lower NIMs through other endogenous adjustments to the way they operate. For instance, banks can pivot to Non-II-generating activities as well as increase their fees.

LLPs: Low interest rates may also affect LLPs. Lower rates make the existing stock of debt easier to service, thereby reducing overall debt burdens and estimated probabilities of default (PDs). These PDs are an important input into banks' forward-looking provisioning models. On the other hand, low interest rates may also lower the quality of new loans through the risk-taking channel of monetary policy. The literature on a risk-taking channel of monetary policy suggests falling interest rates can increase risk-taking by banks in three ways. First, lower profits and sticky nominal return targets can increase banks' willingness to extend loans to riskier borrowers (Rajan 2006; Haldane 2011). Second, higher income and collateral values may lead to falling risk perceptions (Jiménez et al 2014). And finally, forward guidance by central banks might reduce risk premia in low-rate environments (Borio and Zhu 2012). However, a risk-taking channel of monetary policy (to the extent that it matters) will only affect the flow of new loans. Given the stock of variable-rate loans is larger than the flow, lower interest rates are expected to lower provisions.

4.1 Other factors

Several other factors mean the channels outlined above are unlikely to have a uniform impact across countries.

Funding behaviour: Differences in the composition of banks' liabilities will affect the impact of very low rates on profits. Funding from wholesale markets (such as bonds) is not constrained by the zero lower bound in contrast to what has been observed for deposit funding. As a result, banks that rely more heavily on wholesale funding markets are less likely to be affected by a reduction in the policy rate from already low levels. Macroeconomic and institutional factors mean that some banking systems make greater use of wholesale funding relative to others. For instance, the Australian, Norwegian and Swedish banking systems are less reliant on deposit funding relative to their international peers, which could be expected to attenuate the impact of lower rates on profitability, all else equal.

Prevalence of fixed rate loans: Countries with a higher share of fixed-rate lending are likely to be more affected by changes in the slope of the yield curve relative to countries with a higher share of variable-rate loans. For example, in France, fixed-rate loans comprise around 90–95 per cent of the stock of lending. This contrasts with other countries such as Canada, where the stock of fixed rates is around one-half, and Sweden and Australia where the share is lower still.

Hedging: Likewise, in countries where hedging is less common – for example, countries in the euro area; see Hoffmann et al (2019) – movements in the yield curve are likely to have a larger impact on bank profits. Ordinarily, NIMs will narrow when yield curves flatten because banks are exposed to interest rate risk from maturity mismatches because of borrowing short and lending long. The extent to which banks reduce their exposure to this risk by hedging will impact their sensitivity to changes in the yield curve.

Banks are also exposed to interest rate risk stemming from holding a greater amount of fixed-rate liabilities (such as non-interest bearing deposits) relative to fixed-rate assets, such that when interest rates decline net income from these positions falls. Banks can choose to hedge this risk using swaps whereby the bank receives cash flows linked to fixed rates and pays cash flows linked to variable rates. As a result, when variable rates decline the income from these hedges increases, thereby providing the necessary hedge. The extent to which some banking systems use interest rate swaps to hedge this risk will also cause differences in the pass through of lower rates to profits in the short run.[10]

Competition: Banks operating in countries with less competitive banking systems will have more pricing power. As a result, following a cut to cash rates, these banks can ensure the fall in their lending rates is closer to the decrease in their funding costs, leaving NIMs less affected than otherwise similar banks operating in more competitive environments.

Central bank term funding facilities: The introduction of various funding schemes since the 2008 financial crisis is another factor that is likely to cause cross-country heterogeneity in the responsiveness of bank profits to lower rates. Term funding schemes involve providing low-cost, longer-term funding to banks, often with incentives for banks to increase their lending to the private sector. These schemes have been used as an alternative tool to provide stimulus when policy rates are near their effective lower bounds. Differences in the availability of these schemes, their design features and take-up across countries are likely to drive differences in the impact of low rates on bank profitability.

Tiered rates in the implementation of monetary policy: Finally, another measure that can be deployed by central banks to address the side effects of low/negative interest rates is a so-called tiering system. For example, the ECB introduced tiering in September 2019 to support the bank-based transmission of monetary policy. Under this scheme, banks' holdings of excess liquidity were exempted from the negative deposit rate facility. As explained later, this system is particularly relevant for French and German banks (both included in our sample) who hold a large share of total system liquidity – see, for example, Baldo et al (2017) and Grossmann-Wirth and Hallinger (2018). Other countries in our sample have also used similar schemes, including Norway and Switzerland.


In the long run these hedges become less effective and so are unlikely to drive cross-country differences in the long-run responsiveness of bank profits to changes in the cash rate. [10]