Will low interest rates increase risk-taking in banks?
What happens when there is persistent low interest rates? How do low interest rates influence bank profitability and risk-taking?
A recently released research analysis by Ender and Neuhoffer (2021) based on literature review and qualitative content analysis showed that when in a low interest rate environment, there is a positive relationship between interest rates and net interest income, while the relationship with non-interest income is negative.
What this means is that if the interest rates go up, the banks’ net interest income increases, while its non-interest income goes down.
What are Net-Interest Income and Non-Interest Income?
Just so that we understand both these terms, Net interest income (NNI) refers to the difference between the revenue generated from a bank's interest-bearing assets (eg loans, mortgages, securities, that creates income from the interest) and the expenses associated with paying interest-bearing debts (https://www.investopedia.com/terms/n/net-interest-income.asp).
On the other hand, non-interest-income includes income from fees like deposit and transaction fees, insufficient funds (NSF) fees, annual fees, monthly account service charges, inactivity fees, check and deposit slip fees (https://www.investopedia.com/terms/n/noninterest-income.asp).
Observations
Interestingly, the research reveals that banks increase their risk-taking behavior mainly through credit risk. This can be observed in their lowering of lending standards or having low loan loss provisions. A low-for long interest rate environment exacerbates this; where low interest rates push banks to “search for yield".
When this happens in a very closely knit fashion, the collective environment causes banks to accept lower yields at higher risks. This is akin to what happened during the 2008 Global Financial Crisis, as banks take on higher risk-taking behaviour as interest rates go lower and lower for longer and longer periods of time.
Collectively seen, banks tend to be negatively influenced by a low interest rate environment. This shows in their reduction in net-interest income, which leads them to move to acquire income in other ways, like increasing fees, or other sources of non-interest income.
Implications
What is important will be the long-term effects of low-for-longer interest rates. There is likely to be mergers of smaller banks into larger counterparts as the costs of running the bank outrun the bank’s profitability in the longer term. Many financial institutions will not be able to do so in a profitable manner and consolidation will make sense, especially so in a digital age where blockchain comes in to disintermediate so many processes.
Source:
Ender and Neuhoffer (2021). IMPLICATIONS OF LOW INTEREST RATES ON BANK PROFITABILITY AND RISK-TAKING.
Yours,
Chief Editor
BBA Market Perspectives
