RDP 2023-05: The Impact of Interest Rates on Bank Profitability: A Retrospective Assessment Using New Cross-country Bank-level Data 7. Empirical Findings across Countries

7.1 Net interest margins

In line with expectations, our estimates point to a clear positive relationship between the short-term interest rate and banks' NIMs during normal times: a fall in the interest rate is associated with a fall in NIMs. From our sample of 10 countries spanning around 1,500 banks, the estimates suggest that during normal times, a 100 basis point reduction in short-term interest rates reduces smaller banks' NIMs by around 5 basis points in the short run (Table 3 top panel; Figure 5, top panel).^[11] The mean long-run impact, calculated using the expression towards the end of Section 6, which assumes the change in interest rates is permanent, is much higher, at around 15 basis points.^[12] Similarly, there is broad-based evidence that a flattening of the yield curve (as measured by the spread between 10-year and 3-month interest rates) is associated with lower NIMs. Our findings are broadly consistent with those reported by Claessens et al (2018) for their sample spanning 47 countries, but is noticeably smaller than the impact reported in Borio et al (2017) for their sample of large, advanced economy banks.

We find limited evidence that the effect of interest-rate changes differs for larger banks compared to smaller banks (Table 3, top panel; Figure 5, bottom panel), though Germany, Canada and Australia are exceptions. In Germany, the expected positive association between short-term interest rates and margins is only evident for larger banks. By contrast, larger Canadian banks' margins appear completely insulated from changes in the short-term interest rate, reflecting the higher degree of diversification between interest and non-interest income. Likewise, in Australia, the impact of a reduction in interest rates on the margins of larger banks is significantly lower relative to smaller banks, possibly reflecting their greater use of wholesale funding markets.

During low interest rate periods, and for most countries, the relationship between the short-term interest rate and NIMs is not statistically distinguishable from that during normal times. In fact, for France, Norway and Poland a further reduction in the cash rate from already low levels appears to have a relatively lower impact on NIMs. For larger banks operating in a low-rate environment, the available evidence tends to suggest that a further reduction in short-term interest rates has a relatively lower impact on NIMs for banks in Germany, France and Switzerland.^[13] This is despite the distribution of liquidity in the euro area, which sees large banks from ‘core’ countries tending to hold large amounts of liquidity in the deposit facility, which should make them more sensitive to reductions in interest rates.^[14] One explanation for this is the ECB's tiering scheme, which may have shielded larger euro area banks' NIMs, although this is unlikely to be a major driver of our results given it was introduced only towards the end of our sample period. Another factor that could have contributed to this result is the increase in high margin lending that was facilitated by the introduction of the Targeted Longer-Term Refinancing Operations II program (Jobst and Lin 2016). Between June 2016 and the end of the period studied, French and German banks could borrow up to 30 per cent of the volume of eligible private non-mortgage loans for a four-year period at the prevailing main refinancing operations (MRO) rate, which was 0 per cent. With lower short-term interest rates compressing NIMs, banks reacted by increasing loan volumes, which were funded at the MRO rate. The increase in volumes led to an increase in NIMs given the favourable spread between lending rates (positive) and the MRO rate (0 per cent).

Next, we examine the effect of policy rates that are not just briefly low but ‘low-for-long’. In these regressions, we replace the ‘low’ dummy variable (a binary variable equal to 1 when interest rates are low and zero otherwise) with a low-for-long variable, equal to the number of time periods during which interest rates have been low. The motivation for doing this is that the nonlinear effects one may expect in a low interest rate environment may materialise with a delay, perhaps because interest rate hedges become less effective over time.^[15] The results are reported in Table 4. To facilitate comparison with the low interest rate findings, Table 4 compares the coefficients for the variables of interest from both specifications: the low-for-long results are in bold, directly below the low interest rate coefficients as reported in Table 3. For brevity, we do not report the coefficients of the non-interacted variables (the interest rate, the yield curve, the dummy for large banks interacted with the interest rate and the yield curve) as they are almost identical to those of Table 3. These additional results are available upon request.

The main takeaway from Table 4 is that the results using the low-for-long variable are qualitatively similar to those using the low dummy. Starting with the effect on the NIM in the top panel, the coefficient of the interacted variable is significant for more countries using the low-for-long variable, suggesting that the effect of low interest rates on NIMs is nonlinear and larger when rates have been kept low for a while. In the case for Australia, Chile, Germany and France, NIMs decline as rates are kept lower-for-longer; however, for Norway, Sweden and Switzerland the reverse is true. For the other dependent variables (discussed in more detail in the next section) there is some weak evidence that the impact of a rate reduction on ROA starts to exert itself slightly more after a period of time (e.g. for smaller Australian and German banks). But overall, the results using the low-for-long variable are similar to those using the low dummy for both ROA and LLPs. For Non-II, there is no evidence of lower-for-longer impacts.

Finally, there is mixed evidence that negative rates exacerbate the detrimental impact of low interest rates on banks' NIMs. In two of the four jurisdictions that have implemented negative short-term interest rates, the marginal impact of a cut to the interest rate is significantly larger in negative-rate environments (Table 5). For German banks, by contrast, a further cut to the short-term rate when it is already negative has a beneficial impact on larger banks' NIMs. For smaller banks, it is the opposite.

One important caveat to this analysis is the limited within-country variation in policy rates once they reach the zero lower bound, which makes it harder to identify the effect on the dependent variable. As a consequence, results need to be interpreted with caution. Still, the results indicate that there is no clear-cut nonlinearity below zero, which is consistent with the mixed findings from the existing literature.

7.2 Overall bank profitability

In Section 7.1, we observed the relationship between short-term interest rates and banks' NIMs during normal times to be positive and significant, as expected. The effect of lower interest rates on overall bank profitability (as measured by banks' ROAs) is less clear owing to other mitigating factors.

Both Table 3 (second panel) and Figure 6 (second panel) show the results for our ROA regression. Our results confirm that there is not a clear-cut association between lower interest rates and overall bank profitability; for about half the sample a reduction in short-term interest rates lowers bank profitability, while for the other half it is associated with an increase in profits. The magnitude of the impact of monetary policy on overall profitability is modest. The largest impact among the 10 countries examined is that a 100 basis point fall in the short-term interest rate is associated with a 6 basis point reduction in smaller banks' ROAs in the short run. These estimates would be smaller still if one were to add back any effects that operate indirectly through monetary policy's effect on aggregate demand.

There is only limited evidence that Non-II has played a counterbalancing role (Table 3, third panel; Figure 6, third panel). That is, there is no consistent result across countries indicating that non-interest income increases as interest rates fall, either owing to one-off revaluations of long-term assets or banks shifting their business towards non-interest sources of income. Nor does the non-interest income effect appear to be significantly different for larger banks or during low-rate periods.

Our results do, however, show that lower rates uniformly lower LLPs by reducing debt-servicing burdens on the stock of existing debt (Table 3, fourth panel; Figure 6, fourth panel). There is no evidence that this effect is meaningfully offset by an increase in risk-taking by banks during low-rate periods (i.e. a risk-taking channel of monetary policy), which would instead result in a positive and significant coefficient on LLPs.

There is considerable country-specific heterogeneity underlying these key results. Some of these quantitative differences are discussed in the next sub-section, including the impact on overall profitability when rates are negative.

To qualitatively inform some of the cross-country differences and unpack some of the attenuating factors that have enabled banks to maintain their level of overall profitability as short-term rates have fallen, we can turn to the insights received from our qualitative survey. Overall, the responses received point to a range of mitigating actions, including banks striving to become more cost efficient and streamlining their business models.

For example, starting first with Canada, responses from our survey indicate that banks whose NIM was affected by the low interest rate environment took considerable measures to safeguard profits by becoming more cost efficient, selling non-core underperforming businesses and pivoting to focus on higher growth areas in the short term. Moreover, in some cases, banks adjusted the pricing of assets/liabilities to preserve spread (e.g. lower deposit rates) to mitigate the impact on margins.

For larger Swiss banks, the survey noted that fee and commission income accounts for the largest share of their operating income, with revenues coming mostly from wealth and asset management businesses. As such, their overall profitability was less affected by the impact of the low-rate environment on interest rate margins and benefited from fee and commission revenue streams. For individual Swiss banks, the survey pointed to evidence of search-for-yield behaviour among smaller banks when interest rates were low and negative as they increased mortgage volumes and took on more risk. Some banks also grew their fee and commission business, particularly in the low interest rate environment.

The qualitative survey responses highlight that in Poland there was little discernible impact of lower rates on overall profitability due to banks increasing the share of more profitable credit products (e.g. consumer loans); a reduction in less profitable credit products; and a decrease of the interest on liabilities. The NIM in Poland remained relatively high compared to other EU countries, which was also related to the level of interest rates in Poland remaining significantly higher than the zero lower bound. In addition, while fee and commission margins have declined – in part due to statutory and regulatory activities aimed at increasing consumer protection by reducing the costs incurred by them – banks were able to reduce their operating costs partly through digitalising processes.

In Australia, lower rates do appear to lower bank profitability. However, the size of this effect is not economically significant. Several factors, highlighted in the qualitative survey, help to explain this result. Around one-third of Australian banks' funding comes from wholesale markets, which is a larger share than for many international banks. The cost of wholesale funding is not constrained by an effective zero lower bound in contrast to what has been observed for deposit interest rates internationally. Moreover, Australian banks tend to have interest rate hedges, which smooth profits and so delays the reduction in profits from falls in interest rates. Moreover, around three-quarters of Australian banks' assets are variable-rate loans that are funded with variable-rate deposits and other debt. The implication of this is that changes in the slope of the yield curve do not have a large impact on Australian banks' profits.

7.2.1 Overall bank profitability: quantitative results in more detail

At the individual country level, several channels are at play. In Canada, Switzerland and Norway there is suggestive evidence that banks have taken measures to offset the low-rate impact on NIMs to safeguard ROAs. That is, in these jurisdictions, the effect of lower interest rates on NIMs has not transferred through to ROAs (Table 3; Figure 6). For Switzerland and Norway, the effect on bank profitability of larger banks differs significantly from smaller banks, with larger banks benefiting from lower rates.

In the case of France, the rate impact on ROAs is almost double in size relative to the impact on NIMs. In the case of the Czech Republic, the magnitude of the rate impact on ROAs is similar in magnitude to that for NIMs but is not statistically significant. However, for the Czech Republic this result does not hold in the low-rate environment. Additional tests indicate that the positive association between NIMs and interest rates only holds when rates are increasing, suggesting banks in the Czech Republic shielded themselves against rate decreases, including through lower loan-loss provisions.

In negative interest rate regimes, we find no clear evidence that the impact of policy on overall profitability is any different, with exceptions for Germany and to some extent Sweden. In Germany, a decline in short-term interest rates reduces ROAs for smaller banks during the low interest rate regime, whereas it seems insignificant during the negative interest rate regime. The insignificant impact might arise from two sub-components of ROAs – the NIM and Non-II – that seem to counterbalance each other: on the one hand, smaller banks seemed to have safeguarded profits by increasing their Non-II (for example, fee and commission income), while on the other hand their NIM declined (Michaelis 2022). This suggests that small banks in Germany found means to shield overall profitability in the face of negative interest rates. The story is different for Sweden. Here, a rate cut during the negative interest rate regime reduces ROAs for smaller banks by much more than during the low interest rate regime.

Footnotes

The full regression outputs are available upon request. [11]

This figure is obtained using the average coefficient on the lagged dependent variable, ${\alpha }_1$, in Equation (1), which is 0.7. [12]

By contrast, for large Canadian banks, there is an interesting nonlinearity: while a rate reduction in normal times does not appear to affect their profitability, a reduction from already low levels is detrimental. This suggests there could be limits to the benefits of diversification for larger Canadian banks. [13]

The ECB deposit facility rate reached zero in July 2012; it became negative in 2014; and was set to –0.40 per cent in 2016 and –0.5 per cent in 2019. [14]

Here we are assuming the marginal impact of being in a low-rate environment changes linearly with the amount of time spent in the low-rate environment. If the impact is nonlinear then it is unclear whether the dummy or our linear variable is a better approximation of the true nonlinear effect. [15]