Bank profitability and risk‐taking under low interest rates

• Date: 01 January 2018
• Published date: 01 January 2018
• DOI: http://doi.org/10.1002/ijfe.1595

RESEARCH ARTICLE

Bank profitability and risk‐taking under low interest rates

Jacob A. Bikker

1,2

| Tobias M. Vervliet

3

1

Supervisory Policy Division, Strategy

Department, De Nederlandsche Bank

(DNB), P.O. Box 98, 1000AB Amsterdam,

Netherlands

2

School of Economics, Utrecht University,

Utrecht, Netherlands

3

DNB, Amsterdam, Netherlands

Correspondence

Jacob A. Bikker, De Nederlandsche Bank

(DNB), Supervisory Policy Division,

Strategy Department, P.O. Box 98, 1000AB

Amsterdam.

Email: j.a.bikker@dnb.nl;

jabikker@hotmail.com

JEL Codes: G21

Abstract

The aim of this paper is to investigate the impact of the unusually low interest

rate environment on the soundness of the United States banking sector in terms

of profitability and risk‐taking. Using both dynamic and static modelling

approaches and various estimation techniques, we find that the low interest

rate environment indeed impairs bank performance and compresses net interest

margins. Nonetheless, banks have been able to maintain their overall level of

profits, due to lowerprovisioning, which in turn may endanger financialstability.

Banks did not compensate for their lower interest income by expanding

operations to include trading activities with a higher risk exposure.

KEYWORDS

Banking, profitability, risk‐taking, (dynamic) panel data models, low interest rate environment,

United States

1|INTRODUCTION

Since the start of the financial crisis, concerns have arisen about

the soundness of the financial sector. The current macroeconomic

conditions and the unseen low interest rates present a challenging

environment for financial institutions. Due to weak economic

growth and lower expected real returns on investment, interest

rates have been falling since the early 2000s all over the world.

Moreover,ascentralbanksattempt to meet their inflation target

levels in order to ameliorate the economic conditions, an expan-

sionarymonetarypolicyhasbeenexercised in the United State,

Europe, and Japan, maintaining short‐term policy rates at near

zero levels. By means of large‐scale asset purchases, the long‐term

interest rates have fallen to historically low levels too.

Studies on bank profitability and its relationship to

the business cycle (see, e.g., Bikker & Hu, 2002; Demirgüç‐

Kunt & Huizinga, 1999) regained considerable attention in

the light of the most recent recession (see Athanaso glou,

Brissimis, & Delis, 2008; Albertazzi & Gambacorta, 2009; Bolt,

de Haan, Hoeberichts, Van Oordt, & Swank, 2012). Bank

profitability is a predominant indicator of a sound and stable

banking sector, but needs further attention in light of the low

interest rate environment. Hitherto, any results on the link

between interest rate levels and bank profitability is merely

aby‐product in the literature. Studies which specifically focus

on the relationship between (low) interest rates and bank

profitability are scarce (see Alessandri & Nelson, 2015;

English, 2002; Genay & Podjasek, 2014). Borio, Gambacorta,

and Hofmann (2015) further stress the importance of under-

standing this relationship for the evaluation of monetary pol-

icyasthisissuspectedtohaveserioussideeffects.

First, this paper aims to contribute to the literature by

further exploring the relationship between bank

profitability and the low interest rate environment. It is

generally supposed that, in the long term, falling interest

rates have a negative effect on bank profits. At first glance,

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This is an open access article under the terms of the Creative Commons Attribution License, which permits use, distribution and reproduction in any medium, provided the

original work is properly cited.

© 2017 The Authors. International Journal of Finance & Economics Published by John Wiley & Sons Ltd

Jacob A. Bikker is affiliated with De Nederlandsche Bank (DNB), Super-

visory Policy Division, Strategy Department, P.O. Box 98, 1000AB

Amsterdam (j.a.bikker@dnb.nl) and School of Economics, Utrecht

University. Tobias M. Vervliet was at DNB when writing this paper.

Received: 25 July 2017 Accepted: 23 September 2017

DOI: 10.1002/ijfe.1595

Int J Fin Econ. 2018;23:3–18. wileyonlinelibrary.com/journal/ijfe 3

banks might be able to compensate for lower lending rates

by correspondingly lowering their funding rates.

However, the funding rate is constrained to a zero lower

bound, as customers are not expected to accept a negative

deposit interest rate. Profit margins are squeezed along

with the net interest margin, and as bank profits

largely determine bank capital, lower profit margins could

put pressure on the bank's capital position and thereby on

its solvancy. This should also be seen in light of

the increasing stringency of capital requirements under

Basel 3.5.

Second, the issue of bank risk‐taking will be

addressed. Banks may have increased their risk appetite

due to the low interest rate environment, yet the extent

to which banks increase their risk exposure through risky

investments in search for higher profits is hardly investi-

gated. Thus far, this potential development has merely

been suggested by, for example, Genay and Podjasek

(2014) and Weistroffer (2013). In the short run, banks

may benefit from lower loan loss provisions as a result

of a reduced default probability on outstanding loans

due to low interest rates for lenders. In the medium term,

low interest rates might trigger banks to lower their lend-

ing standards which could cause a deterioration in the

quality of the loan portfolio, raising credit risk.

This paper explores the impact of the low interest rate

environment on both bank profitability and bank risk‐

taking by analysing a dynamic panel model which

considers persistence effects, bank‐specific, and macro-

economic determinants, as well as the interest rate

environment. In order to account for the dynamic

structure and the potential endogeneity, a system general-

ized method of moments (GMM) estimator is used.

Alternatively, a static modelling approach is employed to

expose relationships of interest.

The remainder of this paper is structured as follows:

The next section provides an overview of the literature

on determinants of bank profitability and on risk‐taking

behaviour of banks. Section 3 presents the data and the

relevant variables for the empirical study on the United

State banking sector. Also, the initial models are specified.

Section 4 describes the methodology and the econometric

techniques used to estimate these models in search for

consistent and reliable estimates. Subsequently, the

empirical results are presented, interpreted, and

discussed. Section 6 provides a conclusion.

2|LITERATURE REVIEW

2.1 |Bank profitability

Identifying the determinants of bank profitability is an

important field of research. Demirgüç‐Kunt and Huizinga

(1999) were among the first to explain differences in bank

profitability and net interest margins. Athanasoglou et al.

(2008) made the popular, more parsimonious decomposi-

tion of determinants into bank‐specific, industry‐specific,

and macroeconomic categories. They adopted a dynamic

model and found significant profit persistence. Many

papers take this profit persistence into account in accor-

dance with Berger, Bonime, Covitz, and Hancock (2000)

(see, e.g., Dietrich & Wanzenried, 2011 for the Swiss

banking sector or Garca‐Herrero, Gavilá, & Santabárbara,

2009 for the case of China, but also Alessandri & Nelson,

2015).

First, numerous bank‐specific factors may affect the

profits of a bank. Commonly used variables are size, bank

capital, the level of (credit) risk, lending, revenue diversi-

fication, the business model or type of bank, efficiency,

and shares of publicly owned banks (see Athanasoglou

et al.,2008). Based on the existing literature, this paper

illustrates how these bank‐specific factors affect bank

profitability.

Size

Empirical evidence on the impact of bank size on prof-

itability is inconclusive. Whereas Borio et al. (2015),

Demirgüç‐Kunt and Huizinga (1999), and Goddard,

Molyneux, and Wilson (2004) find a positive effect,

ECB (2015) finds that bank size has a significantly neg-

ative effect on profitability, which is explained by the

more complex and costly structure of larger banks. On

the other hand, Athanasoglou et al. (2008) and Truji-

llo‐Ponce (2013) find an insignificant effect and suggest

a non‐linear relationship such that profitability initially

increases with size and then declines. Berger and Hum-

phrey (1994) remark on the consensus in the literature

that the average cost curve in banking has a relatively

flat U‐shape with medium‐sized banks being slightly

more scale efficient than either large or small banks.

Others such as Shehzad, De Haan, and Scholtens

(2013) find that larger banks are more profitable than

small banks but grow at a slower pace. Larger banks

may benefit from economies of scale whereas smaller

banks may try to grow faster at the expense of their

profitability.

Capital

Bank capitalization, measured as the ratio of equity to

assets, is another factor influencing bank profitability.

Relying on the effects of the Basel Accords which require

banks to have a minimum level of capital as a percentage

of risk‐weighted assets (RWA), Iannotta, Nocera, and

Sironi (2007) state that higher capital levels may denote

banks with riskier assets. This at least holds for a given

RWA leverage ratio, that is, the ratio of capital to RWA.

4BIKKER AND VERVLIET