Oliver Brenman, Frank Eich, and Jumana Saleheen
The conventional wisdom amongst financial market observers, academics, and journalists is that a steeper yield curve should be good news for bank profitability. The argument goes that because banks borrow short and lend long, a steeper yield curve would raise the wedge between rates paid on liabilities and received on assets – the so-called “net interest margin” (or NIM). In this post, we present cross-country evidence that challenges this view. Our results suggest that it is the level of long-term interest rates, rather than the slope of the yield curve, that drives banks’ NIMs.
Net interest margins are calculated as the interest banks earn on their assets—e.g. on the loans they make — minus the interest they pay out on their liabilities – e.g. the interest they pay to savers. Meanwhile, the slope of the yield curve is defined as the difference between the long-term interest rate (10 year government bond) and a short-term rate.
The conventional wisdom follows from banks’ fundamental business model— to act as maturity transformers by borrowing short term (e.g. from deposit accounts) and lending long term (e.g. through mortgages or loans to companies). This activity is typically profitable as short-term interest rates are usually lower than long- term interest rates. This reflects the fact that depositors are generally willing to sacrifice returns because they value the liquidity of holding their money in cash rather than in an illiquid investment. Figure 1 illustrates this with the aid of a stylised yield curve. In the example, a bank issues a loan at 3.5%, matched with bank deposits of shorter maturities offering an interest rate of 1%. If the long rate rose to 5%, it would steepen the yield curve, increase the interest rate spread between lending and borrowing, and increase the NIMs.
Figure 1: Illustration of maturity transformation
It is worth noting that we wouldn’t expect this theoretical relationship, between the slope of the yield curve and NIMs, to hold perfectly in the real world. For example, NIMs capture much more than just the gains of maturity transformation. For example, NIMs also reflect the rewards banks collect for bearing different types of risk (e.g. credit risk).
Stemming from this understanding of maturity and liquidity transformation Bill English observes that this intuitive positive relationship has been the conventional wisdom for some time.
We find no systematic positive relationship between the slope of the yield curve and NIMs
However, a very simple plot of the slope of the yield curve and the NIM does not deliver a positive relationship (Figure 2). Instead, the slope goes the wrong way – it is negative for the UK confirmed by a simple regression – suggesting that an increase in the slope of the yield curve lowers the NIM. Indeed Table 1 (below) shows that this negative relationship arises in all countries in our sample bar the US, a point observed by a Liberty Street Economics blog post.
Figure 2: Simple plot of the slope of the yield curve and average bank NIMs in the United Kingdom
Sources: World Bank, OECD, SNL and authors calculations.
It is worth noting that in recent decades the countries in our sample have been through large economic, structural and policy changes, such as the introduction of inflation targeting, and changes in competition, financial liberalisation and regulation. These changes no doubt will have some impact on the slope of the yield curve and its relationship with NIMs, but those are beyond the scope of this article.
2) So how do interest rates affect NIMs?
Motivated by this discovery, we sought to inspect how the individual components of the slope of the yield curve (the short and long rate) affect NIMs. We find that the long rate is more important than the short rate in determining NIMs in a very simple regression model. The long rate has a higher coefficient and is statistically significant for most countries. The short rate is closer to zero and is insignificant for most countries, apart from Italy and Spain. Overall though, we find that a steepening of the yield curve is generally associated with a fall in the NIM (Table 1).
Table 1: For most countries a steepening of the yield curve has historically been associated with a fall in the net interest margin, while higher long rates with an increase
Sources: World Bank, OECD, SNL database and Bank calculations.
From this we conclude that, when it comes to interest rates, the long-term interest rate (unlike the short-term interest rate and the slope of yield curve) has a substantial positive impact on bank NIMs. This finding helps to explain why an upwards parallel shift in the yield curve is good for net interest margins (because while the slope does not change the long rate goes up). It is worth remembering that the results are driven by the average maturity and composition of assets and liabilities of bank balance sheets. If the structure of their balance sheets changes, so too might these results.
What do these findings tell us about the past and the future?
The long rate in many economies has fallen gradually over time since the late 1980s. Our simple empirical results suggest that there would be a corresponding fall in bank NIMs. Figure 3 shows that while that relationship held in the UK prior to the financial crisis, it appears to have broken down since – as the NIM has flattened out in recent years, despite the continued fall in the long rate. This isn’t just a UK phenomenon — NIMs in other countries have remained relatively stable since the global financial crisis too, despite falling long-term interest rates in these economies (Figure 4). This may be because of the large macroeconomic and financial shocks that affected banks, or because banks have changed their business models and the structure of their balance sheets. This is beyond the remit of this article. In light of this caveat it is hard to say with certainty whether this observed relationship between long rates and NIMs will reinstate itself or not; it is too early to tell.
Figure 3: UK banks’ net interest margins and the long-term interest rate have historically moved closely together but the relationship appears to have weakened post financial crisis
Sources: World Bank, OECD, SNL and Bank calculations.
Figure 4: Post crisis bank net interest margins have remained remarkably stable, despite significant falls in interest rates
Sources: World Bank, OECD, SNL and Bank calculations.
Conclusions
Some central banks, such as the Fed and the Bank of England, have started the tightening phase of monetary policy, which has been associated with a steepening of the yield curve. The commonly held view is that such a steepening of the yield curve should be unequivocally good news for bank profitability because it raises banks’ net interest margins. This article challenges that conventional wisdom. Using data for a panel of 10 countries over four decades, we find no systematic positive relationship between the slope of the yield curve and bank net interest margins. Instead, we find that long-term interest rate tend to drive bank margins. But even this latter relationship has weakened since the global financial crisis. This suggests there is much uncertainty about the future relationship between interest rates and bank profitability.
Frank Eich works in the Bank’s International Surveillance Division. Jumana Saleheen works in the Bank’s Financial Stability, Strategy and Risk Directorate. This post was written whilst Oliver Brenman was working in the Bank’s Policy and Strategy Division.
If you want to get in touch, please email us at bankunderground@bankofengland.co.uk or leave a comment below.
Comments will only appear once approved by a moderator, and are only published where a full name is supplied.
Bank Underground is a blog for Bank of England staff to share views that challenge – or support – prevailing policy orthodoxies. The views expressed here are those of the authors, and are not necessarily those of the Bank of England, or its policy committees.
Are you saying that the yield curve will steepen without the LT rate going up? In other words, only medium term rates will change?
If not, then how can the yield curve steepen without LT rates going up?
Firstly, it is encouraging, from a prudential viewpoint, to read that the Bank of England is conducting in depth research into the impact of a steeper yield curve. The paper raises a number of important points, and the following observations may be of relevance.
1. A key factor is financial market rationale for both a steeper yield curve and a higher level of long- term rates. Longer term sterling rates are determined by a number of factors, notably the expected path of sterling bank rate, and the expected path of the both the UK and global economy (and hence fund manager asset allocation between fixed interest securities and equities / other investments). In my lengthy experience of treasury management, international factors (especially the consensus forecast path of the US and Chinese economies) are significant drivers of longer-term sterling fixed interest rates. Another important factor is prudential policy – notably the requirement to maintain an adequate level of liquidity. There have also been a number of occasions when political factors have impacted on long term UK interest rates – both short term fears and longer term UK political / geopolitical risks.
2. From a bank profitability viewpoint, the slope of the yield curve can often be a more significant, longer term, than the level of long -term rates. A very steep yield is normally associated with an eventual significant slowdown in the economy, as the monetary authorities aggressively tighten monetary policy. Such an environment is normally associated with a slowdown in the level of UK business activity, in response to both actual and anticipated monetary policy tightening. In this scenario of a slowing economy, aggregate demand for bank loans – and hence bank profitability, diminishes. Bank profitability tends to increase after the yield curve peaks – as the curve gradually flattens. In this environment, the level of mainstream business activity steadily increases, whilst a competent bank treasury should make significant profit from prudent investment in long dated fixed rate bonds (normally high grade government or corporate bonds).
3. Long term rates probably have a smaller impact on bank profitability than the consensus view. Many banks hedge long term interest rate exposure, thus matching their variable rate liabilities with variable rate assets (fixed interest assets hedged by interest rate swaps or more sophisticated hedging mechanisms).
4. A rise in long- term rates is good for banks short term, due to the factors referred to in the paper. The impact of these factors diminishes as the economy slows in response to significant monetary tightening.
One penultimate observation. The paper makes reference to banks. Similar principles apply to building societies and many other financial intermediaries.
The final observation. The title of one of my professional bodies has very recently changed to The Society of Professional Economists. This reflects an attempt to widen the scope of economic debate, by increasing the potential for links between business economists and those working in other fields, notably the academic and government sectors. This initiative may well enhance the links between the Bank of England and business sector economists – especially given that former BOE Deputy Governor, Professor Charles Bean, is a Deputy President of the enhanced professional body.
Laurence Russell Sanders
Member, Association of Corporate Treasurers; Member, Society of Professional Economists
Independent Economic and Treasury Advisor