Bank Profitability and Interest Rates

Like any other business, banking, be it commercial or investment involves making profits in multiple ways to remain competitive. Apart from earning money for shareholders, banks need to make enough to pay employees and maintain the buildings in which they are located. Monetary policy is known to affect bank profitability. The effect is produced on net interest income, non-interest income, and loan loss provisions. However, bank profitability is dependent on a variety of factors, both internal and external. These aspects regulate the level of success of any bank to the greatest extent.

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Banks’ profitability largely depends on two types of factors: internal (bank-specific) and external (macroeconomic and industry-specific). Internal elements include the return on assets ratio, liquidity risk, cost income ratio, net credit facilities to total assets ratio, total equity to assets ratio, total investment to total assets ratio, net credit facilities to total deposits ratio, and bank size (Almazari, 2014). Other important internal factors are a credit risk, capital adequacy, management efficiency, and business mix indicator (Petria, Capraru, & Ihnatov, 2015). All of these aspects have a profound effect on the way banks make profits.

The return on assets is the ratio “of net income to total assets” (Almazari, 2014, p. 132). In any bank, this ratio is contingent on the decisions made by the bank, as well as on uncontrollable resolutions associated with government policies and economic conditions. The size and efficiency of a bank play a crucial role in its profitability (Almazari, 2014; Trujillo-Ponce, 2013). Thus, bank owners need to pay thorough attention to the variety of internal factors that can affect banks’ profits.

External considerations are not less important in defining banks’ profitability. The most crucial factors in this category are inflation, economic growth, and market concentration (Petria et al., 2015). The dependence of profitability on inflation is linked to inflation’s impact on operating costs and salaries (Trujillo-Ponce, 2013). Moreover, the extent of inflation’s effect is determined by the level of anticipation demonstrated by a bank. If the management foresees inflation and is prepared for it, the bank is capable of adjusting interest rates and, as a result, reinforcing revenues faster than costs (Trujillo-Ponce, 2013).

In such a case, chances for profitability will be increased. The relation between economic growth and banks’ profitability is another crucial issue to consider. Unfavorable economic circumstances can deteriorate the loan portfolio’s quality, thus producing credit losses and raising the provisions held by banks (Trujillo-Ponce, 2013). On the contrary, the enhancement of economic conditions, along with the improved solvency of borrowers, escalates the demand for credit by companies and households, which leads to positive outcomes for banks’ profitability. Finally, market concentration has a favorable impact on profitability due to creating benefits for market power.

A crucial effect on bank profitability is produced by monetary policy. In particular, three aspects of such an impact are outlined: the influence on loan loss provisions, on non-interest income, and net interest income. Borio, Gambacorta, and Hofmann (2017) analyze how the interest rate level and the slope of the yield curve can influence the profitability elements. The relationship between these two factors is considered to be particularly strong at very low levels of nominal interest rates (Borio et al., 2017). Speaking about the level of interest rates, scholars outline two relevant mechanisms:

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  • a “retail deposits endowment effect”
  • a “quantity effect” that counterbalances the “price effect” (Borio et al., 2017, p. 50).

The slope of the yield curve also affects net interest income since any considerable changes occurring in it can influence banks’ fixed-rate mortgages.

The effect of interest rate level and the yield curve slope on non-interest income and loan loss provisions is also considerable. The two major impacts that can be produced by high-interest rates on non-interest income are

  • valuation effects on securities
  • commissions and fees (Borio et al., 2017).

The influence on the profit-and-loss account is contingent on accounting conventions. Meanwhile, higher interest rates and a steeper yield-curve slope are considered to be associated with higher loan losses (Borio et al., 2017). The sensitivity of this factor can also increase when interest rates are very low. Such a situation is possible because low rates are inclined to control following financial crises when the balance sheets of both banks and their customers are in poor condition.

There is a close relationship between bank profits and interest rate management. As Claessens, Coleman, and Donnelly (2018) note, interest rates have been low for nearly ten years, starting with the global financial crisis of 2008. Claessens et al. (2018) remark that low-interest rates lead to negative effects on bank profitability since it increases with the rise of interest rates. When interest rates hike, banks obtain large cash holdings because of business activities and customer balances. Although low-interest rates can promote the recovery of the economy, their persistent low level can deteriorate the profits of banks. As a result, banks do not tend to lower deposit rates willingly, especially when such a request comes from retail depositors.

Another effect of interest rate management on bank profitability is related to risk-taking. Research by Dell’Ariccia, Laeven, and Marquez (2014) indicates that declines in real interest rates can cause higher risk and greater leverage for “any downward sloping loan demand function” (p. 65). It is the case for banks that can regulate their capital structures. However, if a bank has a fixed capital structure, the impact of interest rates is contingent on the degree of leverage. After a decrease in interest rates, the risk of banks that are capitalized is ascended, whereas in the case of linear loan demand, the risk of highly levered banks is descended (Dell’Ariccia et al., 2014). Thus, interest rate management is important when predicting or mitigating risks.

The profitability of a bank depends on a variety of internal and external factors. Internal involve, among others, the cost-income ratio, return on assets ratio, total investment to total assets ratio, total equity to assets ratio, net credit facilities to total deposits ratio, bank size, and management efficiency. External features are represented by inflation, economic growth, and market concentration. Apart from these issues, profitability is closely associated with monetary policy.

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Interest rate management is a significant component of reaching banks’ profitability. This factor also affects the process of risk management in financial institutions. The questions that require further consideration are concerned with finding solutions to minimizing risks for banks under the condition of low interest rates. Also, it would be relevant to investigate which of the internal factors has the greatest effect on banks’ profitability.

References

Almazari, A. A. (2014). Impact of internal factors on bank profitability: Comparative study between Saudi Arabia and Jordan. Journal of Applied Finance & Banking, 4(1), 125-140.

Borio, C., Gambacorta, L., & Hofmann, B. (2017). The influence of monetary policy on bank profitability. International Finance, 20, 48-63.

Claessens, S., Coleman, N., & Donnelly, M. (2018). “Low-for-long” interest rates and banks’ interest margins and profitability: Cross-country evidence. Journal of Financial Intermediation, 35, 1-16.

Dell’Ariccia, G., Laeven, L., & Marquez, R. (2014). Real interest rates, leverage, and bank risk-taking. Journal of Economic Theory, 149, 65-99.

Petria, N., Capraru, B., & Ihnatov, I. (2015). Determinants of banks’ profitability: Evidence from EU 27 banking systems. Procedia Economics and Finance, 20, 518-524.

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Trujillo-Ponce, A. (2013). What determines the profitability of banks? Evidence from Spain. Accounting and Finance, 53, 561-586.

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