How do Bank Profits Change in Response to Changes in Interest Rates?

Abstract

The conventional view suggests that bank profits and interest rates are expected to move together. When interest rates increase, banks make more money on loans and other assets. However, prior studies have often examined this relationship without distinguishing between various types of banks. This misses important nuances in the relationship between interest rates and profits. This paper incorporates local factors to determine if different types of banks are more sensitive to these nuances as they deal with interest rate changes, employing bank-level Call Report data from the Federal Deposit Insurance Corporation covering the 1987–2020 period. The local indicators used in the study came from the Bureau of Labor Statistics and the Bureau of Economic Analysis. Banks are also categorized based on size and whether they are community banks or not to test whether the determinants of profits differ across these categories. The findings reveal that while the conventional view holds true for mid-size banks, higher interest rates negatively affected the profitability of community banks, as well as large banks, for different reasons. Community banks do not have access to tools to isolate themselves from the increased defaults that the local economy may experience because of increasing interest rates. On the other hand, large banks are known to engage in more investment banking activities. High interest rates hurt these banks by killing lucrative investment-bank revenues, which results in lower overall profits.