The global financial crisis of 2007–2009 and the ensuing period of low interest rates have renewed interest among policy makers in the relationship between bank profitability and financial stability. Despite the subsequent recovery, the return on equity of many banks remains below the cost of equity. Market valuations remain below the balance sheet value of banks, indicating the market’s assessment of banks’ ability to overcome profitability challenges is not optimistic.
In a recent IMF Working Paper, we look into how bank profitability affects financial stability from both theoretical and empirical perspectives. We developed a theoretical model of the relationship between bank profitability and financial stability by exploring the role of non-interest income and retail-oriented business models. We then analyzed data from 431 publicly traded banks to examine the determinants of bank risks and profitability, and how the level and the source of bank profitability affect risks. In this regard, we analyzed not only the link between the level of bank profitability and financial stability, but also the deeper question of how the source of bank profitability affects financial stability.
While the level of bank profitability is important for financial stability it matters greatly where a bank’s profits come from.
The banks in the study included all global systemically important banks worldwide, and all public banks in the U.S. and developed Europe. The sample period spans 2004 to 2017. We found evidence that higher profitability is associated with lower risks not only at the individual institution level, but also at the system level, measured by the contribution to systemic risks.
High profits lower risk in two ways. Profits tend to build up buffers against negative shocks. And the prospect of future profits restrains banks’ risk-taking behavior as they have more “skin in the game.” While the level of bank profitability is important for financial stability it matters greatly where a bank’s profits come from.
In the low-interest-rate environment following the global financial crisis, banks diversified by looking for non-interest sources of income. Increased reliance on non-interest income tends to be associated with heightened risks for banks, measured both at the firm level and in terms of the contribution to systemic risk. The level of increased risk depends on a bank’s business model. While non-interest income activities could provide some diversification benefits for retail-oriented banks with a relatively high loan-to-asset ratio, an over-reliance on non-interest income could lead to higher risks.
Yet not all types of non-interest income activities generate the same level of risk. Retail-oriented banks may be more inclined to choose retail-oriented non-interest income activities, because they are complementary to their existing lending customer base. Some examples of retail-oriented non-interest income include payment services fees (such as credit card fees) and insurance commissions. These activities tend to offer stable profits and the benefits of diversification.
By contrast, less retail-oriented banks may derive a relatively large share of the non-interest income from market-based activities, such as underwriting, market-making, trading, and investment-banking services. These activities tend to generate more volatile and procyclical income and are associated with higher risks, both to individual institutions and to the financial system. Similarly, other characteristics of wholesale-oriented business models—including high leverage, and reliance on wholesale funding sources—are also associated with heightened risks.
A close link also exists between competition and financial stability. 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. While the ability to mark up prices benefits an individual bank, it could increase risks at the systemic level due to the excessive market power of some banks. This finding is particularly relevant given the rise in bank consolidation following the global financial crisis.
What does this mean for the policy makers?
First, the results highlight the need for a sharper distinction between different types of non-interest income, recognizing that market-based non-interest activities are riskier than retail-based activities.
Second, it’s important to account for the impact of bank consolidation on competition and systemic risk. Policy makers need to 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.
Third, these results show the need to evaluate the source and sustainability of bank profits, especially when there is over-reliance on non-interest income, wholesale funding, and leverage. Paying more attention to these issues can help policy makers to better design and calibrate stress tests and systemic risk analysis.