Bank profitability and interest rate risk

Abstract

It is frequently asserted that the profitability of institutions that lend long and borrow short is restricted during periods of rising interest rates. In banking circles this assertion has been translated into a concern primarily for the soundness of smaller banks, which are commonly thought to hold a large proportion of their portfolios in longer term fixed-rate loans and thus face considerable interest rate risk. Moreover, with the popularity of the new “NOW” accounts and competing money market mutual funds, there is a fear that a potential profit squeeze at these institutions has been made more probable. The present study examines the issue of the interest rate sensitivity of commercial bank profitability at a theoretical level and attempts to measure empirically the extent to which the profitability of different size classes of banks has been affected by periods of changing interest rates since 1976. This study finds that small commercial banks as a group have actually experienced increased profitability both absolutely and relative to large banks in recent periods (since 1976) of rising interest rates. However, this variation is numerically small. This finding calls into question both the usefulness of the maturity composition model as a predictor of interest rate risk and the concern for the supposed plight of small banks during periods of rising interest rates.