Determinants of Bank Interest Margins: Impact of Maturity Transformation

Abstract

This paper explores the extent to which interest risk exposure is priced in bank margins.Our contribution to the literature is twofold: First, we present an extended model of Ho and Saunders (1981) that explicitly captures interest rate risk and returns from maturity transformation. Banks price interest risk according to their individual exposure separately in loan and deposit rates, but reduce these charges when they expect returns from maturity transformation. Second, using a comprehensive dataset covering the German universal banks between 2000 and 2009, we test the model-implied hypotheses not only for the commonly investigated net interest income, but additionally for interest income and expenses separately.Controlling for earnings from bank-individual maturity transformation strategies, we find all banks to charge additional fees for macroeconomic interest volatility exposure. Microeco- Non-technical summaryBanks are intermediaries between investors and entrepreneurs. They transform long-term, illiquid and risky loans into safe deposits that are due within short notice. By doing so, they take risks, for which they are remunerated. Besides, they can generate income by making use of their market power and by setting their credit and deposit conditions accordingly. In a theoretical model, we show that the bank rates are set in accordance with the costs and earnings caused by the loans and deposits. In addition, banks levy premia for credit and interest rate risk, and for the access to the capital market. We derive the following empirically testable hypotheses:The margins on the asset side should be the higher, the stronger the market power, the more volatile the interest rates and the credit risk and the greater the exposure to interest rate risk.The model also predicts that banks smooth their interest rates (relative to the interest rates observed on the capital market). Accordingly, on the liability side, we expect the same factors to have an impact, expect for the credit risk, which is here not relevant. In an empirical study of all German universal banks for the period 2000 -2009, we obtain the following results:1. The statements derived from the theoretical model can be confirmed in our study, in particular we find that the higher the market power the higher the interest income margin and the lower the interest expense margin.2. The interest rate margins increase for all banks, in the event that the interest rates become more volatile. Additionally, for banks from the savings and credit cooperative sectors, we see the smoothing of bank rates that is predicted by the theoretical model. Nichttechnische Zusammenfassung

Market Timing, Maturity Mismatch, and Risk Management: Evidence from the Banking Industry

“…In Germany, especially the smaller savings and cooperative banks have stable, homogeneous business models with a focus on granting loans and accepting deposits. Assuming that a bank's on-balance-sheet maturity structure remains stable through replacement of maturing assets and liabilities with new business of the same initial maturity, Memmel (2008) and Entrop et al (2012) prove that the majority of German banks' interest income and expenses can be explained, and thus the authors give support to the empirical validity of the assumptions underlying the estimators.…”

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“…Specifically, Maudos and De Guevara (2004) introduce a model that explains a NIM that increases as a result of higher operational costs and these authors refer to 8 the negligence of controlling for operational efficiency as a potential omitted variable bias of all prior studies explaining the NIM. Broad empirical evidence indicates that NIMs decline (rise) as operational costs decrease (increase) (Entrop et al, 2012;Maudos and Solis, 2009;Clayes and Vander Vennet, 2008;Carbo and Fernandez, 2007). This strand of the literature is highly supportive of our hypothesis, as a change in NIM is likely to cause higher interest paid on liabilities and/or lower credit rates charged.…”

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“…regulation, efficiency of banks, liquidity of banks and lastly, economic factors. However, as Entrop et al (2015) postulate, banks increase loan interest rates and fees and decrease deposit interest rates and fees according to the size of the maturity gap (as a result of the maturity structure of an individual bank), i.e. banks holding long-term loans in their balances increase loan interest rates and fees in order to compensate for the risk they undertake.…”