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Does a steeper yield curve help banks?

Bank net interest margins seem to depend on the level of interest rates but this relationship is more complicated than the data alone suggests.

Bank net interest margins seem to depend on the level of interest rates but this relationship is more complicated than the data alone suggests.

A steeper yield curve – the difference between short and long maturity interest rates – is widely believed to boost the profitability of commercial banks.

This is because the basic business model of banks is maturity transformation – borrowing short (from deposits etc.) and lending long (e.g. mortgages or corporate loans). As the gap between short term and long term interest rates increases (i.e. the yield curve steepens), the wedge between the rates bank pay on liabilities and receive on assets should also widen.

This gap between what banks pay on liabilities and receive on assets is known as the net interest margin (NIM) and is an important driver of bank profitability. While NIMs also capture payment credit risk and other risks taken by banks, it makes intuitive sense that a steeper yield curve should translate into a higher NIM and greater bank profitability.

It is the level of interest rates, not the shape of the curve, that seems to matter empirically.

However, a recent study by the Bank of England (BOE) finds no systematic positive relationship between the yield curve slope and NIMs. In fact, in the UK, the relationship seems to be the other way round, with a steeper yield curve associated with lower NIMs. The only country in the Bank’s sample of 10 countries that showed a (weak) positive relationship between yield curve slope and NIMs was the U.S.

Instead, the Bank finds that it is the level of the long term interest rate on its own (rather than the short rate or the spread between the two) that has a large positive relationship with NIMs. So a higher long term interest rate (including a parallel shift in the yield curve to higher interest rates) leads to higher NIMs. The same relationship can be seen in data for the U.S., where NIMs were lower during the period of 2009-16 when rates were low than they were in earlier years, even when the curve steepness was the same. It is the level of interest rates, not the shape of the curve, that seems to matter empirically.

NIMs have stabilized

Despite both long term interest rates and NIMs falling since the 1980s, it is notable that NIMs across developed countries have stabilized since the global financial crisis, even as long term rates have continued their decline.

What is so striking about this stabilization in NIMs is that for most of the crisis period, short-term risk-free rates have been close to or below zero. Because banks tend to be reluctant to charge depositors negative rates (perhaps because of psychological factors that make negative nominal rates particularly unattractive to households), there has in effect been a floor on how much banks can reduce their funding costs. 

In this environment, you might expect a fall in long term rates to be particularly damaging to NIMs, as the return on assets shrinks while the cost of finance remains the same.

This suggests that banks are not passive takers of the prevailing interest rate environment, but are capable of restructuring their business in the face of changing interest rates. For example, as short term interest rates fall, banks can substitute away from retail deposits and towards other sources of funding, including the cheap funding schemes put in place by various central banks, such as the Funding for Lending Scheme in the UK .

Furthermore, the level of interest rates is not independent of the state of the economy, but both a reflection and determinant of economic trends. The decline of interest rates over the last 30 years has been in part a function of a number of real factors, including demographics, productivity, and inequality. 

To the extent that these same factors also impact bank profitability, the empirical relationship between NIMs and interest rates might overstate the causal power of interest rates on NIMs.

Along with these real factors, central banks have been trying to push interest rates lower to ease financial conditions and boost the economy. It is possible that the net impact of this was to improve bank profitability, as it helped to improve the economy and reduce the risk of default on loans.

So it is far from clear there is a straightforward relationship between NIMs and interest rates. As interest rates rise it may well be that NIMs also start to improve, but this is likely to be in part a function of the economic strength that is driving rates higher.

Important Information

Fixed income securities are subject to certain risks including, but not limited to: interest rate (changes in interest rates may cause a decline in the market value of an investment), credit (changes in the financial condition of the issuer, borrower, counterparty, or underlying collateral), prepayment (debt issuers may repay or refinance their loans or obligations earlier than anticipated), and extension (principal repayments may not occur as quickly as anticipated, causing the expected maturity of a security to increase).

Foreign securities are more volatile, harder to price and less liquid than U.S. securities. They are subject to different accounting and regulatory standards, and political and economic risks. These risks may be enhanced in emerging markets countries.

Image credit: Design Pics Inc / Alamy Stock Photo

ID: US-150518-65161-1





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