The quest for growth: The impact of bank strategy on interest margins

Abstract

This paper proposes an alternative explanation for the decline in bank interest margins in many developed countries, which, in our view, better fits the empirical and narrative evidence on bank behavior in the run-up to the credit crisis. A common thread in the literature on bank interest margins is a causality that runs from competition to lower margins to new activities. The causal chain that we propose runs from ROE maximization to asset growth to lower interest margins. The key difference with the traditional explanation is that banks' quest for growth, not the level of competition in traditional retail segments, has transformed banks' balance sheets and reduced interest margins. Underlying this transformation is the strategic shift from relationship to transaction banking. In support of our explanation, this paper presents empirical evidence for banks in the euro area. Our results document a significant, positive impact of relationship banking on interest margins.