Impact of a low-for-long interest rate environment on banks profitability

Abstract

Previously, the low interest rate environment has been related to supporting inflation and economic activity in the wake of the global financial crisis of 2008. Until recently, this Low-For-Long (LFL) interest rate environment is a source of risk because of its potential effects on banks' profitability and consequently on financial stability.

In the academic literature, the impact of LFL interest rates on bank profitability has been discussed by several authors and in different economies around the world. It was found that there are several oppositions between central bank economists and academic economists. The former did not consider that the expansionary monetary policy had a negative effect on bank profitability, and, therefore, did not have a negative effect on the economy through the banking system. The latter, however, argued that the effect of the LFL on banking channels was negative and thus had a negative effect on the economy. The opposing views of the different authors are reflected in the ambivalent results of studies. While some point at the potential negative effects on bank profitability, others argue that the effect is neutral. These oppositions stem from the ambiguous results of recent empirical work on this issue.

In contrast to the relationship between profitability and interest rates, the scientific literature is not very developed on the relationship between bank risk-taking and low interest rates. This research thesis presents an empirical analysis to measure the impact of low interest rates on the risk-taking and profitability of banks in the euro area (EA).

To carry out our empirical study, the use of a fixed effect model allows us to analyse the relationship between interest rates and profitability as well as risk-taking of banks in the EA. To do so, annual data from 85 major European banks directly supervised by the ECB over 20 years, from 2000 to 2020, are used to empirically estimate the above relationship.

Based on our regression results, the impact of low interest rates is found to have a positive effect on ROA while the effect is negative for the NIM. Regarding the relationship between banks' risk-taking and low interest rates, the effects are positive for risk-taking. Despite our various models and analyses, it would be wrong to draw a hasty conclusion.

A theoretical discussion of the impact of an increase in the European Central Bank's key interest rate on bank profitability and risk-taking is presented at the end of this research paper.