Bank Profitability: Consider the Source

IMF Blog, April 30, 2019

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Bank Profitability: Consider the Source

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Bibliographic details

• Authors: Udaibir S Das, Kun Hu, TengTeng Xu
• Published: April 30, 2019

Overview and research design

• Authors: Udaibir S. Das, Kun Hu, TengTeng Xu
• Date: April 30, 2019
• Context: The global financial crisis of 2007–2009 and the ensuing period of low interest rates renewed interest in the relationship between bank profitability and financial stability.
• Data and sample:
  • 431 publicly traded banks.
  • Sample period: 2004 to 2017.
  • Sample includes all global systemically important banks worldwide, and all public banks in the U.S. and developed Europe.
• Analytical approach:
  • Theoretical model exploring the relationship between bank profitability and financial stability, with explicit focus on non-interest income and retail-oriented business models.
  • Empirical analysis of determinants of bank risks and profitability, and how the level and the source of bank profitability affect risks, at both the institution and system levels.

Key empirical findings

• Profitability and risk:
  • Higher profitability is associated with lower risks at the individual institution level.
  • Higher profitability is associated with lower contribution to systemic risk.
  • High profits lower risk through two channels:
  • Profits build up buffers against negative shocks.
  • Prospect of future profits restrains risk-taking because banks have more “skin in the game.”
• Source of profits matters:
  • Increased reliance on non-interest income tends to be associated with heightened risks at the firm level and in terms of contribution to systemic risk.
  • The risk impact of non-interest income depends on a bank’s business model:
  • Retail-oriented banks (relatively high loan-to-asset ratio) can obtain diversification benefits from non-interest income when it is retail-oriented.
  • Over-reliance on non-interest income can lead to higher risks.
• Types of non-interest income:
  • Retail-oriented non-interest income examples: payment services fees (such as credit card fees) and insurance commissions.
  • These activities tend to offer stable profits and diversification benefits.
  • Market-based non-interest income examples: underwriting, market-making, trading, and investment-banking services.
  • These activities tend to generate more volatile and procyclical income and are associated with higher risks at both the individual and system levels.
• Business model characteristics associated with heightened risks:
  • Wholesale-oriented business models.
  • High leverage.
  • Reliance on wholesale funding sources.
• Competition and systemic risk:
  • Banks with higher market power—as measured by the Lerner index of their ability to mark up prices—tend to be associated with lower risks at the individual bank level but higher contribution to systemic risk.
  • Excessive market power (for example, from consolidation) can increase systemic risk despite reducing individual-bank risk.

Policy implications and recommendations

• Distinguish types of non-interest income:
  • Recognize that market-based non-interest activities are riskier than retail-based activities when assessing bank stability.
• Monitor consolidation and competition effects:
  • Account for the impact of bank consolidation on competition and systemic risk.
  • Strike a balance between cost-saving consolidation and a competitive banking environment.
  • One approach to foster competition is to allow for the entry of new firms into the financial sector instead of raising excessive domestic and foreign barriers to entry.
• Evaluate source and sustainability of profits in supervisory frameworks:
  • Pay attention to over-reliance on non-interest income, wholesale funding, and leverage when designing and calibrating stress tests and systemic risk analysis.
  • Incorporate the source and sustainability of bank profits into assessments of financial stability.

Source: IMF blog post “Bank Profitability: Consider the Source,” Udaibir S. Das, Kun Hu, TengTeng Xu, April 30, 2019.

References

• Working Paper