The Sensitivity of Bank Net Interest Margins and Profitability To Credit, Interest-Rate, and Term-Structure Shocks Across Bank Product Specializations

Abstract

This paper presents a dynamic model of bank behavior that explains net interest margin changes for different groups of banks in response to credit, interest-rate, and term-structure shocks. Using quarterly data from 1986 to 2003, we find that banks with different product-line specializations and asset sizes respond in predictable yet fundamentally dissimilar ways to these shocks. Banks in most bank groups are sensitive in varying degrees to credit, interest-rate, and term-structure shocks. Large and more diversified banks seem to be less sensitive to interest- rate and term-structure shocks, but more sensitive to credit shocks. We also find that the composition of assets and liabilities, in terms of their repricing frequencies, helps amplify or moderate the effects of changes and volatility in short-term interest rates on bank net interest margins, depending on the direction of the repricing mismatch. We also analyze subsample periods that represent different legislative, regulatory, and economic environments and find that most banks continue to be sensitive to credit, interest-rate, and term-structure shocks. However, the sensitivity to term-structure shocks seems to have lessened over time for certain groups of banks, although the results are not universal. In addition, our results show that banks in general are not able to hedge fully against interest-rate volatility. The sensitivity of net interest margins to interest-rate volatility for different groups of banks varies across subsample periods; this varying sensitivity could reflect interest-rate regime shifts as well as the degree of hedging activities and market competition. Finally, by investigating the sensitivity of ROA to interest-rate and credit shocks, we have some evidence that banks of different specializations were able to price actual and expected changes in credit risk more efficiently in the recent period than in previous periods. These results also demonstrate that banks of all specializations try to offset adverse changes in net interest margins so as to mute their effect on reported after-tax earnings.