How have banks responded to changes in the yield curve?

Abstract

a cumulative increase in the federal funds rate of 200 basis points was accompanied by a compression of 125 basis points in the difference between the yields on three-month and ten-year U.S. Treasury securities. In this Chicago Fed Letter, we examine some of the effects of the flatter yield curve on the banking sector and how they compare with the effects of similar interest rate configurations in the past. A common feature of monetary policy tightening episodes, when the Federal Reserve raises the federal funds rate, is a flattening of the bond yield curve. This happens as the federal funds rate and other short-term interest rates move up faster than long-term rates, compressing the spread between short-and long-term rates. In this article, we examine some of the effects of a flatter yield curve on the banking sector. Because banks make most of their money by borrowing and lending at different interest rates, the slope of the yield curve has important implications for their profitability and equity values; therefore, it has the potential to affect banks' decisions about lending and risk-taking. Inspired by the theoretical literature, we consider two stylized financial intermediaries: a "retail" bank that relies largely on core deposits and has mostly variable-rate loans on the asset side; and a "wholesale" bank that is funded in wholesale markets and has long-duration, fixed-rate assets. We trace out the effects of a flatter yield curve on these banks' profitability and equity, and we discuss possible implications for their risk-taking incentives. To address the implications for the banking system as a whole, we look at the relative importance of the retail and wholesale models over time. For concreteness, we focus on three episodes of yield-curve flattening: from (see figure 1). In addition to short-term interest rates rising faster than long-term rates, all of these episodes were characterized by relatively benign economic conditions. In the most recent episode, we show that the flattening of the yield curve has been associated with an increase in the average bank's net interest margin (NIM), which is roughly the difference between the rate it earns on its assets and the rate it pays on its liabilities. 1 The observation that NIMs are rising with a flatter yield curve reflects in part a post-crisis shift of the banking sector