Low Interest Rates and Risk taking channel of Monetary Policy

From Monetary Policy and Bank Risk Taking

Gianni De Nicolò, Giovanni Dell’Ariccia, Luc Laeven, and Fabian Valencia
July 27, 2010

Part of the blame for the current global financial crisis has fallen, justly or not, on monetary policy. The story goes more or less like this: persistently low real interest rates fueled a boom in asset prices and securitized credit and led financial institutions to take on increasing risk and leverage. Had central banks preempted this buildup of risk by raising interest rates earlier and more aggressively, the consequences of the burst would have been much less severe.1

This claim has become increasingly popular in both academia and the business press, partly because the crisis occurred in the wake of a prolonged period of exceptionally low interest rates and lax liquidity conditions. However, little empirical evidence has been presented to back it up. And theory has had surprisingly little to offer on the subject. Few macroeconomic models have explicitly considered the impact of policy rates on bank risk taking. And models of bank risk taking have yet to incorporate the effects of monetary policy.

From The risk-taking channel of monetary policy in the USA: Evidence from micro-level data

A recent line of research suggests that there is a significant link between a monetary policy of low interest rates over an extended period of time and higher risk-taking by banks. This link points to a different dimension of the monetary transmission mechanism, the so-called risk-taking channel of monetary policy transmission (Borio and Zhu, 2008)

From The risk-taking channel of monetary policy in the USA: Evidence from micro-level data

For many decades commercial banks in the USA operated under a very restrictive regulatory environment. The McFadden Act (1927) restricted commercial banks from intra- and inter-state expansion of their branch network without previous regulatory approval. Furthermore, the Glass- Steagall Act (1933) prohibited, among other things, commercial banks from offering investment services, such as corporate underwriting, securities brokerage, real estate sales or insurance. These Acts meant to increase competition, protect small banks and limit their risk-taking behavior. Eventually, both Acts were repealed by the end of the 1990s; this allowed commercial banks to freely expand their network across counties and states and to join their forces with other financial institutions. Whether the removal of these restrictions on US banking activity has led to a decrease or increase in banks’ risk-taking behavior is an open debate in economic research. Mishkin (1999), for example, argues that the separation of the banking and securities industries restricted the ability of the banks to diversify, and thus to reduce risk. Then again, the demise of the Glass-Steagall Act led to large financial institutions and the well-known moral hazard problem created by a too-big-to- fail policy. This policy seems to have encouraged increased risk taking on the part of large US banks (Boyd and Gertler, 1993).

From The risk-taking channel of monetary policy in the USA: Evidence from micro-level data

Regardless its (questionable) impact on banks’ risk-taking behavior, the fact is that financial deregulation significantly reduced the number of insured US commercial banks from over 14,000 in 1985 to approximately 6,500 in 2010. At the same time, banking industry assets increased significantly from $2.73 trillion in 1985 to $12.1 trillion in 2010. However, this increase was not evenly distributed across the US banking industry and the sector became far more concentrated than during most of its past. For example, the asset share of the largest size group (i.e. organizations with more than $1 billion in assets) rose dramatically from 71% in 1992 to 90% in 2010.

From The risk-taking channel of monetary policy in the USA: Evidence from micro-level data

In this paper, we do not investigate the underlying factors of this consolidation trend. Instead, our focus is primarily on identifying how the gradual restructuring of the US banking industry (in its various manifestations), along with the varying macroeconomic conditions, have influenced the linkage between interest rates and bank risk-taking over time. Hence, adding a temporal dimension to the analysis allows us to better understand the dynamics of the risk-taking channel of the US monetary policy transmission over the last two decades. Throughout this period, the federal funds rate (the primary tool used for implementing monetary policy) varied significantly in accordance with the country’s economic conditions. During the 2000s, the Fed adopted accommodative monetary policies. Following the bursting of the dotcom bubble in late 2000 and the subsequent recession in the US economy, the Federal Open Market Committee (FOMC) began to lower the target for the overnight federal funds rate. Rates fell from 6.5% in late 2000 to 1.75% in December 2001 and to 1% in June 2003. The target rate was left at about 1% for a year. At that time, the historically low federal funds rate resulted in a negative real federal funds rate from November 2002 to August 2005. Remarkably, since the first quarter of 2009 the level of federal funds rate has remained at its all-time low (0.25%). This exceptionally low level is likely to hold for an extended period of time as evidenced by the minutes of the FOMC’s meeting April 27, 2011.

From The risk-taking channel of monetary policy in the USA: Evidence from micro-level data

 

In forming its central-bank policy rates, the Fed, like other central banks, has the mandate of promoting price stability. However, unlike other banks, the Fed is additionally charged with promoting maximum employment. This dual mandate may well explain the Fed’s recent decision to embark on quantitative easing schemes in an attempt to keep interest rates at low levels in order to promote employment. Although these monetary policy decisions may potentially impair the performance of the banking sector, or change the structure of its risk-taking activities, the Fed avoids taking actions against financial volatility per se, or against banks taking losses or failing. Such actions are believed to raise moral hazard problems, which could ultimately increase, rather than reduce, the risks to the financial system (Plosser, 2007). Thus, the current (and expected) accommodative monetary policy implies that the Fed is more concerned with liquidity injections that facilitate the orderly functioning of the financial markets, rather than protecting banks from the consequences of their financial choices.

Key Research/Analysis Sources:

A) Monetary policy, interest rates and risk-taking

Mikael apel and Carl andreas Claussen; 2012

 

Click to access rap_pov_artikel_4_120607_eng.pdf

 

B) Monetary Policy and Bank Risk-Taking: Evidence from the Corporate Loan Market

Teodora Paligorova∗ Bank of Canada

Jo ̃ao A. C. Santos∗

November 22, 2012

 

http://www.frbsf.org/economic-research/events/2013/january/federal-reserve-day-ahead-financial-markets institutions/files/Session_3_Paper_2_Paligorova_Santos_risk_taking.pdf

 

C) Monetary policy and the risk-taking channel 

Leonardo Gambacorta
Bank for International Settlements (BIS)

BIS Quarterly Review December 2009

Click to access r_qt0912f.pdf

 

D) Capital Flows and the Risk-Taking Channel of Monetary Policy

Valentina Bruno Hyun Song Shin

December 19, 2012

http://citeseerx.ist.psu.edu/viewdoc/download?doi=10.1.1.269.6716&rep=rep1&type=pdf

 

 

E) Bank Risk-Taking, Securitization, Supervision, and Low Interest Rates: Evidence from Lending Standards

Angela Maddaloni and José-Luis Peydró

September 2009

Click to access Shangai_Jan2010.pdf

 

F) Capital regulation, Risk-Taking and Monetary Policy: A Missing Link in the Transmission Mechanism ?

24-25 September 2009

Claudio Borio

Haibin Zhu

http://citeseerx.ist.psu.edu/viewdoc/download?doi=10.1.1.184.5606&rep=rep1&type=pdf

 

G) Monetary Policy and Bank Risk Taking

Prepared by Gianni De Nicolò, Giovanni Dell’Ariccia, Luc Laeven, and Fabian Valencia* Authorized for Distribution by Olivier Blanchard
July 27, 2010

http://citeseerx.ist.psu.edu/viewdoc/download?doi=10.1.1.172.813&rep=rep1&type=pdf

 

H) Conducting Monetary Policy at Very Low Short-Term Interest Rates

By BEN S. BERNANKE AND VINCENT R. REINHART

MAy 2004

http://citeseerx.ist.psu.edu/viewdoc/download?doi=10.1.1.480.5070&rep=rep1&type=pdf

 

I) Does Monetary Policy Affect Bank Risk?

Yener Altunbasa, Leonardo Gambacortab, and David Marques-Ibanezc

March 2014

Click to access 05anares.pdf

 

J) Interest rates and bank risk-taking

Manthos D Delis and Georgios Kouretas

January 2010

Click to access Interest_rates_and_bank_risk-taking.pdf

 

K) Monetary Policy, Leverage, and Bank Risk-Taking

Giovanni Dell’Ariccia Luc Laeven Robert Marquez

December 2010

Click to access wp10276.pdf

 

L) The risk-taking channel of monetary policy in the USA: Evidence from micro-level data

Manthos D Delis and Iftekhar Hasan and Nikolaos Mylonidis

October 2011

Click to access MPRA_paper_34084.pdf

 

 

M) Bank Leverage and Monetary Policy’s Risk-Taking Channel: Evidence from the United States

Giovanni Dell’Ariccia Luc Laeven Gustavo Suarez

2016

https://www.ecb.europa.eu/pub/pdf/scpwps/ecbwp1903.en.pdf?17ecd6a759787404e7fa0ede3a8ec8c3

 

 

N) Money, Liquidity, and Monetary Policy

Tobias Adrian Hyun Song Shin

January 2009

 

Click to access sr360.pdf

 

O) In search for yield?
Survey-based evidence on bank risk taking

Claudia M. Buch

Sandra Eickmeier

Esteban Prieto

2011

 

 https://www.bundesbank.de/Redaktion/EN/Downloads/Publications/Discussion_Paper_1/2011/2011_05_13_dkp_10.pdf?__blob=publicationFile

 

P) DOES MONETARY POLICY AFFECT BANK RISK-TAKING?

by Yener Altunbas, Leonardo Gambacorta and David Marqués-Ibáñez

2010

 

 

Q) Monetary policy and the risk-Taking channel: Insights from the lending behaviour of banks

Teodora Paligorova and Jesus A. Sierra Jimenez

2012

 

 

Funding Strategies of Banks

Deposit vs non deposit funding

On the liabilities side of Banks balance sheets, deposits provide source of funding but due to decline in deposits, banks have moved to other sources of funding mainly from wholesale money markets.

This has caused the problems.

From Short-term Wholesale Funding and Systemic Risk: A Global CoVaR Approach

 

Financial institutions use short-term wholesale funding to supplement retail deposits and expand their balance sheets. These funds are typically raised on a short-term rollover basis with instruments such as large-denomination certificates of deposit, brokered deposits, central bank funds, commercial paper and repurchase agreements. Whereas it is agreed that wholesale funding provides certain managerial advantages (see Huang and Ratnovski, 2011, for a discussion), the effects on systemic risk of an overreliance on these liabilities were under-recognized prior to the recent financial crisis. Banks with excessive short- term funding ratios are typically more interconnected to other banks, exposed to a high degree of maturity mismatch, and more vulnerable to market conditions and liquidity risk. These features can critically increase the vulnerability not only of interbank markets and money market mutual funds, which act as wholesale providers of liquidity, but eventually of the whole financial system.

From THE DARK SIDE OF BANK WHOLESALE FUNDING

 

Banks increasingly borrow short-term wholesale funds to supplement retail deposits (Feldman and Schmidt, 2001). Through wholesale money markets, they attract cash surpluses from non financial corporations, households (via money market mutual funds), other financial institutions, etc. Wholesale funds are usually raised on a short-term rollover basis with instruments such as large-denomination certificates of deposits, brokered deposits, repurchase agreements, Fed funds, and commercial paper.

From this paper:  Lenders on the storm of wholesale funding shocks: Saved by the central bank?

The purpose of this paper is to add to a better understanding of the risks posed by banks’ reliance on wholesale funding. Wholesale funding refers to the use of deposits and other liabilities from institutions such as banks, pension funds, money market mutual funds and other financial intermediaries. When a bank relies on short-term wholesale funds to support long-term illiquid assets, it becomes vulnerable to runs by wholesale creditors. This risk manifested itself since the start of the financial crisis in 2007, when banks were confronted with severe strains in funding liquidity. Interbank funding dried up, causing interbank money market spreads to soar (Figure 1). After the failure of Lehman Brothers in 2008, this was soon followed by the drying up of wholesale funding markets. The functioning of those markets was severely undermined by increased counterparty risk and a shortage of high-quality collateral. From 2011 onward, when the financial crisis was followed by the sovereign debt crisis, banks in peripheral euro area countries even faced an accelerating outflow of retail funding, normally one of the most stable funding sources. Those funding strains forced banks to adjust their balance sheets in various ways. They responded by reducing maturity mismatches, switching to alternative sources of finance and by deleveraging. This activated the so-called liquidity channel of financial transmission through which funding liquidity shocks are propagated to bank lending and the real economy (BCBS, 2011). Our paper provides new empirical insights into the working of the liquidity channel.

From this paper: Executive Compensation and Systemic Risk: The Role of Non-Interest Income and Wholesale Funding

Furthermore, if the non-interest activities are financed through an unstable source of funds, the higher the non-traditional activity, the higher the liquidity exposure. In fact, the excessive overreliance on unstable wholesale funding makes banks more vulnerable to liquidity shocks in money markets. This proved to be a major driver in amplifying and transmitting the idiosyncratic shocks initiated in the U.S. real estate sector to a global scale during the recent financial crisis, generating large externalities to the real economy.

 

From this paper: Executive Compensation and Systemic Risk: The Role of Non-Interest Income and Wholesale Funding

While wholesale markets seem to provide an unlimited source of fast and cheap funding that banks use to expand their balance sheets, non-interest activities largely increase banking profitability, all together granting constant dividends and substantial bonus payments in the sector. A likely explanation is that bank managers may have imprudently over-relied on non- interest income sources and whole-sale funding owing to personal objectives, leading their firms (and the whole sector) to an inappropriate level of risk-taking. In spite of the considerable attention this moral hazard problem attracts, the empirical relation between managerial compensation and abnormal risk-taking, sourced in income-generating activities and funding strategies, must still be formally analyzed.

 

Key Research/Analysis Sources:

 

Short-term Wholesale Funding and Systemic Risk: A Global CoVaR Approach

German Lopez-Espinosa, Antonio Moreno, Antonio Rubia, Laura Valderrama

February 2012

Click to access wp1246.pdf

 

 

The Dark Side of Bank Wholesale Funding

Rocco Huang and Lev Ratnovski

2010

Click to access wp10170.pdf

 

Lenders on the storm of wholesale funding shocks: Saved by the central bank?

 

Click to access ecbwp1884.en.pdf

May 2016

 

BANK ACTIVITY AND FUNDING STRATEGIES: THE IMPACT ON RISK AND RETURN

By Asli Demirgüç-Kunt, Harry Huizinga

January 2009

http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1350235

 

BANK RISK DURING THE FINANCIAL CRISIS

DO BUSINESS MODELS MATTER?

by Yener Altunbas, Simone Manganelli and David Marques-Ibanez

Click to access Bank_risk%20during_financial_crisis_business_models_matter_European_Central_Bank.pdf

 

Bank Funding Structures and Risk: Evidence from the Global Financial Crisis

Francisco Vazquez and Pablo Federico

Click to access wp1229.pdf

 

Is There a Role for Funding in Explaining Recent U.S. Banks’ Failures?

Pierluigi Bologna1

July 2011

Click to access wp11180.pdf

 

Executive Compensation and Systemic Risk: The Role of Non-Interest Income and Wholesale Funding

Marina Balboa, Germán López-Espinosa, Korok Ray, Antonio Rubia

Working Paper No.04/12

October 2012

 

Click to access 1352748639_WP_UNAV_04_12.pdf

 

Bank funding costs: what are they, what determines them and why do they matter?

 

Click to access qb14q4prereleasebankfundingcosts.pdf

 

CHANGES IN BANK FUNDING PATTERNS AND FINANCIAL STABILITY RISKS

 

Global Financial Stability Report 2013, Chapter 3

Click to access c3.pdf

 

“Short-Term Wholesale Funding Risks”

Eric S. Rosengren

Global Banking Standards and Regulatory and Supervisory Priorities in the Americas

Lima, Peru November 5, 2014

Click to access 110514text.pdf

https://www.bostonfed.org/news/speeches/rosengren/2014/110514/

 

Deposit Market Competition, Wholesale Funding, and Bank Risk

Ben R. Craig  and Valeriya Dinger

 

Click to access Craig_Dinger.pdf

The Effect of Monetary Policy on Bank Wholesale Funding

Dong Beom Choi  Hyun-Soo Choi

February 23, 2016

 

http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2713538

 

Wholesale Funding Runs

Christophe Pérignon David Thesmar  Guillaume Vuillemey

November 21, 2015

 

Click to access 20151201-Article.pdf

 

When the Rivers Run Dry: Liquidity and the Use of Wholesale Funds in the Transmission of the U.S. Subprime Crisis

Claudio Raddatz

December, 2010

 

The Risks of Bank Wholesale Funding

Rocco Huang Lev Ratnovski

April 2008

Click to access s2p1-ratnovski.pdf

 

 

 

 

 

 

Non Interest Income of Banks: Diversification and Consolidation

Why has Net interest income declined over the years? Particularly between 1980 – 2000

Why has Non Interest Income increased over the years? Particularly between 1980-2000

 

 

Mergers, Consolidation, Bank Failures, Diversification, Deregulation, Competition

Merger activity and overall consolidation are of particular interest in the U.S. banking industry. Since 1980, the structure of the U.S. banking industry has changed considerably, with over 10,000 mergers involving more than $7 trillion in acquired assets taking place. Furthermore, the number of institutions has declined dramatically over this period, and the concentration of assets held by the largest institutions has increased. There were 19,069 banks and thrifts operating in the U.S. in 1980 and 7,011 in 2010, a decline of over 60 percent. In 1980, the 10 largest banking organizations held only 13.5 percent of banking assets, increasing to 36 percent by 2000. By 2010, the 10 largest organizations held approximately 50 percent of banking assets. 

Changes in Regulation

The banking industry has undergone significant regulatory changes in the past 15 years. These regulatory changes have had significant effects on competition and structure, with some changes acting as the impetus for recent merger waves. For example, the Riegle–Neal Interstate Banking and Branching Efficiency Act of 1994 allowed branch banking beyond one state and throughout the United States, and the Gramm–Leach–Bliley Act of 1999 (Financial Services Modernization Act) allowed banks to enter other financial markets and provide additional financial services. Both of these laws are potential causes for the increase in bank mergers. With such regulatory changes and the overall changes in the bank industry structure, banking has moved from a fragmented industry with banks operating only in individual states to a more unified industry, dominated by banks operating in large regions of the country.

Growth through Diversification (Product Mix):

From Banks’ Non-Interest Income and Systemic Risk:

However, prior the crisis, banks have increasingly earned a higher proportion of their profits from non-interest income compared to interest income. Non-interest income includes activities such as income from trading and securitization, investment banking and advisory fees, brokerage commissions, venture capital, and fiduciary income, and gains on non-hedging derivatives. These activities are different from the traditional deposit taking and lending functions of banks. In these activities banks are competing with other capital market intermediaries such as hedge funds, mutual funds, investment banks, insurance companies and private equity funds, all of whom do not have federal deposit insurance.

From Non interest Income and Financial Performance at U.S. Commercial Banks

Much of the empirical literature in commercial banking has followed these rich theoretical leads, analyzing the financial flows fundamental to the intermediation process (e.g., interest paid on deposits, interest received from loans and securities, and the resulting net interest margins) and the risks associated with those flows (e.g., liquidity risk associated with deposits, credit risk associated with loans, market risk associated with fixed income securities, and interest-rate risk associated with the relative maturities of deposits, loans, and securities). However, commercial bank business models have evolved over the past two decades, and today banks generate an increased portion of their income from non intermediation and/or non interest activities. For example, between 1980 and 2001 non interest income in the U.S. commercial banking system increased from 0.77% to 2.39% of aggregate banking industry assets, and increased from 20.31% to 42.20% of aggregate banking industry operating income.

 

From Non interest Income and Financial Performance at U.S. Commercial Banks

The across-the-board growth of non interest income at commercial banks suggests that intermediation activities are becoming a less important part of banking business strategies. The data displayed in Figure 1 suggest otherwise. If intermediation activities have become less important for banks over time, it stands to reason that the correlation between bank profitability and bank net interest margin would grow weaker over time. Figure 1, which displays the average correlation of ROE and net interest margin each year between 1984 and 2001, shows no such weakening. Although these data are crude and exhibit substantial noise over time, they suggest an intriguing possibility: increased noninterest income is co-existing with, rather than replacing, intermediation activities at the typical commercial bank.

Technological and Financial Innovation:

From Non interest Income and Financial Performance at U.S. Commercial Banks

Advances in information and communications technology (e.g., the Internet, ATMs), new intermediation technologies (e.g., loan securitizations, credit scoring), and the introduction and expansion of financial instruments and markets (high-yield bonds, commercial paper, financial derivatives) all would have occurred in the absence of deregulation. But deregulation allowed banks to achieve the scale to use these new technologies more efficiently, and the increased competition induced by deregulation provided banks with the incentives to adopt and adapt these new technologies. Many of these new technologies have emphasized noninterest income while de-emphasizing interest income at banks. Banks can extract fee income from customers willing to pay a “convenience premium” for doing their banking at ATMs or over the Internet. Banks can earn loan origination, loan securitization, and loan servicing fees to offset the interest income that they lost with the disintermediation of consumer lending (e.g., mortages, credit cards). Banks can earn fees from selling back-up lines of credit to firms that float commercial paper rather than borrowing from banks.

Large Banks seems to have larger proportion of their income from Non Interest Income.  Smaller banks still depend on deposits and intermediation for source of their income.

 

 

Key data and Research/Analysis sources:

 

a) Bank’s Non-Interest Income to Total Income for United States

https://research.stlouisfed.org/fred2/series/DDEI03USA156NWDB

 

b) Banks Prime loan Rate

https://research.stlouisfed.org/fred2/series/MPRIME

 

c) Banks’ Non-Interest Income and Systemic Risk

Markus K. Brunnermeier,a Gang Dong,b and Darius Paliab

2012

 

http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1786738

 

d) How do banks make money? The fallacies of fee income

Robert DeYoung and Tara Rice

Click to access ep_4qtr2004_part3_DeYoung_Rice.pdf

 

e) Non-interest income and total income stability

 

Rosie Smith Christos Staikouras and Geoffrey Wood

Click to access wp198.pdf

 

f) What Does the Financial Crisis Teach Us

about Different Banking Models?

Volume 4, Number 3, Spring 2010

Click to access What_Does_the_Financial.pdf

 

g) Diversification in Banking
Is Noninterest Income the Answer?

Kevin J. Stiroh∗
September 23, 2002

Click to access sr154.pdf

 

h) Non interest Income and Financial Performance at U.S. Commercial Banks

Robert DeYoung Tara Rice

 

Click to access sr-2003-2-pdf.pdf

 

I) Banks Non-Interest Income and Global Financial Stability

Robert F. Engle

Fariborz Moshirian

Sidharth Sahgal

Bohui Zhang

2014

http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2443181&download=yes

 

J) Non-Interest Income Activities and Bank Lending

Pejman Abedifar, Philip Molyneux†c, Amine Tarazi

Click to access S10_P1_PejmanAbedifar.pdf

 

K) How do banks make money? A variety of business strategies

Click to access ep-4qtr2004-part4-deyoung-rice-pdf.pdf

 

L) How bank business models drive interest margins: Evidence from U.S. bank-level data

Saskia E. van Ewijk , Ivo J.M. Arnold

August 2012

Click to access 2-Van-Ewijk-How-bank-business-models-drive-interest-margins_aug2012.pdf

 

M) Banking in the United States

Robert DeYoung University of Kansas

2009

http://citeseerx.ist.psu.edu/viewdoc/download?doi=10.1.1.537.3184&rep=rep1&type=pdf

 

N) Nontraditional Banking Activities and Bank Failures During the Financial Crisis

Gokhan Torna

Robert DeYoung

http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2032246&download=yes

 

O) The Decline of Traditional Banking: Implications for Financial Stability and Regulatory Policy

Franklin R. Edwards and Frederic S. Mishkin

1995

Click to access 9507edwa.pdf

 

P) The trade-off between bank fees and net interest margins.

By Barry Williams and Gulasekaran Rajaguru

 

Q) The chicken or the egg? The trade-off between bank fee income and net interest margins

Barry Williams Bond University, Gulasekaran Rajaguru

 

 

R) The Darkside of Diversification: The Case of U.S. Financial Holding Companies

Kevin J. Stiroh and Adrienne Rumble

November 2003

Click to access The%20dark%20side%20of%20diversification.pdf

 

S) The consolidation of the financial services industry: Causes, consequences, and implications for the future

Allen N. Berger Rebecca S. Demsetz , Philip E. Strahan

http://leeds-faculty.colorado.edu/bhagat/ConsolidationFinancialServicesIndustry.pdf

 

T) The Outlook for the U.S. Banking Industry: What Does the Experience of the 1980s and 1990s Tell Us?

Kenneth Spong and Richard J. Sullivan

https://www.kansascityfed.org/publicat/econrev/PDF/4q99spon.pdf

 

U) Do Large Banks have Lower Costs?
New Estimates of Returns to Scale for U.S. Banks

David C. Wheelock and
Paul W. Wilson

Click to access 2009-054.pdf

 

V) The Geographic Distribution and Characteristics of U.S. Bank Failures, 2007-2010: Do Bank Failures Still Reflect Local Economic Conditions?

Craig P. Aubuchon and David C. Wheelock

Click to access Aubuchon.pdf

 

W) Banking Industry Consolidation and Market Structure: Impact of the Financial Crisis and Recession

David C. Wheelock

Click to access 419-438Wheelock.pdf

 

X) Consolidation and Merger Activity in the United States Banking Industry from 2000 through 2010

Robert M. Adams 2012

Click to access 201251pap.pdf

 

 

Bank Mergers and Banking Structure in the United States, 1980-98
By Stephen A. Rhoades

2000

 https://www.federalreserve.gov/pubs/staffstudies/2000-present/ss174.pdf

 

Y) Bank Mergers and Industrywide Structure, 1980–94

Stephen A. Rhoades

1996

Click to access ss169.pdf

 

Z) Bank Merger Activity in the United States, 1994–2003

Steven J. Pilloff

Click to access ss176.pdf

 

 

AA) Consolidation in the U.S. Banking Industry: Is the “Long, Strange Trip” About to End?

 

Kenneth D. Jones and Tim Critchfield

2005

Click to access article2.pdf

 

AB) The Transformation of the U.S. Banking Industry: What a Long, Strange Trip It’s Been

By: Allen N. Berger, Anil K. Kashyap and Joseph M. Scalise

1995

http://www.brookings.edu/about/projects/bpea/papers/1995/us-banking-industry-transformation-berger

 

AC) Consolidation in US Banking: Which Banks Engage in Mergers?

David C. Wheelock and
Paul W. Wilson

December 2002

 

Click to access 6608425.pdf

 

AD) Bank Consolidation: A Central Banker’s  Perspective

Fredric S. Mishkin

1996

Click to access w5849.pdf

 

AE) The Transformation of the U.S. Financial Services Industry, 1975-2000: Competition, Consolidation and Increased Risks

Arthur E. Wilmarth Jr.,

2002

http://scholarship.law.gwu.edu/cgi/viewcontent.cgi?article=2158&context=faculty_publications

 

AF) CONTROLLING SYSTEMIC RISK IN AN ERA OF FINANCIAL CONSOLIDATION

Arthur E. Wilmarth, Jr.

2002

Click to access wilmar.pdf

 

AG) How do changes in Market Interest rates affect Bank Profits?

Flannery, Mark J.

Business Review Sep (1980): 13-22.

 

 

AH) Bank profitability and the business cycle

by Ugo Albertazzi and Leonardo Gambacorta

 

 

 

Impact of Low Interest Rates on Bank’s Profitability

What is Impact of Low Interest rates on Banks’ profitability?

Fed reserve sets the monetary policy for improving employment and controlling inflation. Policy is implemented through setting up policy interest rates.

I point you to three charts below:

Effective Fed funds rate (EFFR). This rate, with high of more than 19 percent in 1981, is at 0.37 percent at present. In November 2008, the rate was at 0.39 percent and has remained low since then.  See reference (m).

Net Interest Margin of Banks has declined: Over the years, the NIM (Net Interest Margin) of banks, a measure of profitability, has eroded. Erosion continues. See the chart below reference (a).

Number of Banks in USA have declined: There were 14400 banks in 1984, 7175 in 2008, and now in 2016, there are only 5309 banks. Banks continue to fail/consolidate (M&A). See the chart below.  reference (b).

 

What does give rise to institutional cash pools and shadow banking, financial innovation (securitization), Bank failures, consolidation (M&A) and evolution of Too Big to Fail Banks, risk taking in lending and financial instability?  Rise in Debt, Credit and Capital Flows?

Too low interest rates for too long.

 

Here are some of the recent publications voicing their concerns:

2015 Annual Report of US Office of Financial Research (OFR) says:

OFR’s assessment of threats to the financial stability of the United States, discusses risk and resilience in the financial system.

The three chief threats are the: (1) impact of persistently low interest rates, (2) increasing debt and declining credit quality in U.S. corporations and emerging markets overseas, and (3) areas of weakness in the system that remain despite financial reforms and better risk management by financial companies. (page 5)

Long-term impact of low interest rates – Although some interest rates have recently moved higher, given the context just described, we expect the incentives for risk-taking from historically low interest rates to endure for some time.

Persistently low rates will continue to prompt investors to take higher risks to increase their returns on investment and may encourage excessive borrowing. (page 6)

At the media briefing of BIS Quarterly Review March 2016, On-the-record remarks by Mr Claudio Borio, Head of the Monetary and Economic Department, 4 March 2016.

But the main source of anxiety was the vision of a future with even lower interest rates, well beyond the horizon, that could cripple banks’ margins, profitability and resilience.

 

BIS views are shaped by the new research published in a paper. See reference (g).

 

Banks stocks are traded on wall street. The CEOS of banks are responsible to show revenue growth and earnings growth every quarter. How do they accomplish that in declining margins environment?

Risk taking, leverage, financial innovation, non-core business, industry consolidation, and aggressive accounting.

 

Fed policies to improve the real economy impact the banking/financial sector adversely.

I suggest that it was due to declining Interest rates in last thirty years that we had Global Financial Crisis.

 

Please take a look at latest data and research/analysis references below.

1. Stijn Claessens, Nicholas Coleman, and Michael Donnelly, “‘Low-for-Long’ Interest Rates and Net Interest Margins of Banks in Advanced Foreign Economies,” Federal Reserve Board of Governors International Finance Discussion Papers Notes, April 11, 2016.
2. Deutsche Bundesbank: Banks’ Net Interest Margin and the Level of Interest Rates; July 2015
3. Atlanta Fed: Net Interest Margin Performance in a Low-Rate Environment 2012
4. Richmond Fed: Do Net Interest Margins and Interest Rates Move Together? May 2016
5. BIS: The influence of monetary policy on bank profitability October 2015
6. FRB: Why are net interest margins of large banks so compressed ? October 2015
7. Chicago Fed: What Is the Impact of a Low Interest Rate Environment on Bank Profitability? July 2014
8. St.Louis Fed: Are Banks More Profitable When Interest Rates Are High or Low? May 2016
9. Bank of England, UK: Simple banking: profitability and the yield curve June 2012

 

Key data and analysis sources:

 

a) Net Interest Margin for all U.S. Banks

https://research.stlouisfed.org/fred2/series/USNIM

 

b) Commercial Banks in the U.S.

https://research.stlouisfed.org/fred2/series/USNUM

 

c) Deutsche Bundesbank (German Central Bank): Banks’ Net Interest Margin and the Level of Interest Rates  July 2015

https://www.bundesbank.de/Redaktion/EN/Downloads/Publications/Discussion_Paper_1/2015/2015_07_14_dkp_16.pdf?__blob=publicationFile

 

d) Stijn Claessens, Nicholas Coleman, and Michael Donnelly, “‘Low-for-Long’ Interest Rates and Net Interest Margins of Banks in Advanced Foreign Economies,” Federal Reserve Board of Governors International Finance Discussion Papers Notes, April 11, 2016.

https://www.federalreserve.gov/econresdata/notes/ifdp-notes/2016/low-for-long-interest-rates-and-net-interest-margins-of-banks-in-advanced-foreign-economies-20160411.html

 

e) Atlanta Fed: Net Interest Margin Performance in a Low-Rate Environment; Viewpoint Vol 25/4, 4th quarter, 2012

https://www.frbatlanta.org/banking/publications/financial-update/12q4/12q4_vp_net_interest.aspx

 

f) Richmond Fed: Do Net Interest Margins and Interest Rates Move Together?; Economic Brief No. 16-05, May 2016

https://www.richmondfed.org/publications/research/economic_brief/2016/eb_16-05

 

g) BIS: The influence of monetary policy on bank profitability; October 2015

Click to access work514.pdf

 

h) OFR Annual Report 2015

Click to access office-of-financial-research-annual-report-2015.pdf

 

i) BIS Quarterly Review March 2016 – Media Briefing

Click to access r_qt1603_ontherecord.pdf

 

j) FRB: Why are net interest margins of large banks so compressed ?; Feds Notes October 2015

https://www.federalreserve.gov/econresdata/notes/feds-notes/2015/why-are-net-interest-margins-of-large-banks-so-compressed-20151005.html

 

k) Chicago Fed: What Is the Impact of a Low Interest Rate Environment on Bank Profitability?; Chicago Fed Letters, No. 324, July 2014

https://www.chicagofed.org/publications/chicago-fed-letter/2014/july-324

 

l) St.Louis Fed: Are Banks More Profitable When Interest Rates Are High or Low?; On the Economy, May 16, 2016

https://www.stlouisfed.org/on-the-economy/2016/may/banks-more-profitable-interest-rates-high-low

 

m) Effective Fed Funds Rate

https://research.stlouisfed.org/fred2/series/FEDFUNDS

 

n) Bank of England, UK: Simple banking: profitability and the yield curve; Piergiorgio Alessandri and Benjamin Nelson; June 2012

Click to access wp452.pdf