The influence of monetary policy on bank profitability

• DOI: http://doi.org/10.1111/infi.12104
• Published date: 01 March 2017
• Author: Boris Hofmann,Claudio Borio,Leonardo Gambacorta
• Date: 01 March 2017

DOI 10.1111/infi.12104

ARTICLE

The influence of monetary policy on bank

profitability

Claudio Borio

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Leonardo Gambacorta

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Boris Hofmann

Monetary and Economic Department,

Bank for International Settlements, Basel,

Switzerland

Correspondence

Boris Hofmann, Monetary and Economic

Department, Bank for International

Settlements, Centralbahnplatz 2, 4002

Basel, Switzerland.

Email: boris.hofmann@bis.org

Abstract

This paper investigates how monetary policy affects bank

profitability. We use data for 109 large international banks

headquartered in 14 major advanced economies for the

period 1995–2012. Overall, we find a positive relationship

between the level of short-term rates and the slope of the

yield curve (the‘interest rate structure’, for short), on the one

hand, and bank profitability—return on assets—on

the other. This suggests that the positive impact of the

interest rate structure on net interest income dominates the

negative one on loan loss provisions and on non-interest

income. We also find that the effect is stronger when the

interest rate level is lower and the slope less steep, that is,

when non-linearities are present.All this suggests that, over

time, unusually low interest ratesand an unusually flat term

structure erode bank profitability.

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INTRODUCTION

Understanding the link between interest rates and bank profitability is important for evaluating the

effect of the monetary policy stance—as captured by the interest rate structure (that is, the level and

slope of the yield curve)—on the soundness of the financial sector. While monetary policy is not, of

course, the only influence on the interest rate structure, it has a major impact on it: the central bank sets

the short-term rate and influences longer-term rates through direct purchases of securities and by

guiding market participants’expectations about the short-term rate.

The link between monetary policy and bank profitability has gained prominence following the

Great Financial Crisis. In the major advanced economies, short-term interest rates have sagged to near

zero and long-term interest rates to historically low levels in many advanced economies. There is

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© 2017 John Wiley & Sons Ltd wileyonlinelibrary.com/journal/infi International Finance. 2017;20:48–63.

widespread agreement that central banks’aggressive response during the early stages of the crisis was

critical to preventing a financial and economic meltdown. However, in recent years there has been

growing concern that the net benefits of prolonged monetary accommodation might be declining due to

its negative side effects (e.g. Bank for International Settlements, 2012; Dale, 2012; Plosser, 2012;

Rajan, 2013). One such side effect is the negative effect of low interest rates on bank profitability and

hence on the soundness of the banking sector.

The link between monetary policy and bank profitability has long been established in the academic

literature (see e.g. Flannery, 1981; Hancock, 1985; Samuelson, 1945). But in recent years it has been

somewhat neglected as a research topic. Only a few studies have focused specifically on the impact of

interest rates on bank profitability. English (2002) studies the link between interest rate risk and bank

interest-rate margins in ten industrialized countries. He finds that, as the average yield on bank assets is

more closely related to long-term rates than the average yield on liabilities, a steep yield curve raises

interest margins. Recently, Alessandri and Nelson (2015) establish a positive long-run link between the

level and slope of the yield curve and bank profitability in the United Kingdom.

In this paper, we explore the link between monetary policy and bank profitability in more depth,

focusing precisely on the relationship between the interest rate structure and bank performance. This,

of course, means that we take macroeconomic conditions as given and do not include any effects that

operate indirectly through monetary policy’s independent impact on aggregate demand.

We contribute to the literature in two main ways. First, we analyse the link more comprehensively,

based on a large set of international banks and all the main components of banks’balance sheets. To

this end, we draw on a data set that covers 109 large international banks headquartered in 14 advanced

economies for the period 1995–2012. And we look at net interest income, non-interest income, loan

loss provisions, and overall return on assets (ROA). Second, we allow for non-linearities in the

relationship between interest rates and bank profitability—an aspect that so far has been neglected in

empirical work despite its intuitive appeal. Importantly, if such non-linearities are sizeable, ignoring

them underestimates the effects of very low interest rates.

The analysis yields the following main results. First, we find a positive relationship between the interest

rate structure and bank profitability. Second, we also find that the impact on profitability declines with the

level of interest rates and the slope of the yield curve—that is, there are significant non-linearities. This

indicates that the impact of interest rates on bank profitability is particularly large when they are low.

The rest of the paper is organized as follows. Section 2 lays out the analytical framework and

considers the main channels through which monetary policy influences bank profitability. Section 3

presents the empirical analysis. It describes the data set, presents the econometric framework, and

discusses the mainempirical results. The conclusion highlightsthe main findings and their implications.

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ANALYTICAL FRAMEWORK

Monetary policy operates primarily through its proximate effect on the short-term interest rate and the

slope of the yield curve. The central bank controls the short-term rate quite closely through the policy

rate. Its influence on the yield curve is more indirect, through its impact on market participants’

expectations about the future policy-rate path (the signalling channel) and through large-scale

operations in government securities specifically intended to have an impact on their price.

Since the crisis, as policy rates have sagged to zero or thereabouts, attempts to influence the yield

curve have become much more prominent as a means of providing extra stimulus. The heavy reliance

on forward guidance about future policy rates and on large-scale asset purchases are testimony to these

efforts. There is growing empirical evidence that, taken together, these policies have had considerable

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