Impact of interest rate on bank soundness and safety

Introduction

Since the financial crisis, the soundness and stability of the banking and financial sector became
important. A more profitable and sound banking sector is able to withstand shocks that may arise
from financial crisis and thus ensuring stability (Aydemir & Ovenc, 2016).

Due to the global financial crisis that has affected the financial sector over the years, the
economic condition continue to worsen, with low expected return on investment and interest rate
as continue to fall. One major factor that has affected the soundness and performance of the
banking sector has been the unstable interest rate. However, financial stability do not rely only
on bank performance but also by the risks they face and how they manage those risks.

Over the years, central banks has introduced various interest rate policy and this policies can
have either a positive or negative impact on the bank’s overall profitability. Interest rate risk is
one of the major risk that banks faces and inadequate management can lead to bank failure. Also,
changes in interest rate affect not only affect the health of banks but also the general economy as
it influence banks willingness to lend capital. Therefore, it is essential for banks to manage
effectively their interest rate risk, also to understand the level of interest rate risk exposure and
how it can affect financial stability and performance.

This paper focuses on the impact of interest rate on banks stability and also how banks
effectively manage their interest rate risk exposure.

Review of interest rate and bank safety

One major tool of monetary policy that central bank uses to control interest rate is either by
imposing high or low interest rate. Central bank through monetary policy raise the interest rate
when the economy is in good condition and lower interest rate when the economy condition
worsens. This interest rate fluctuation affect the financial strength of banks and also its overall
performance specifically its net income margin and its net worth. Short and long term interest
rate alongside yield curve determine banks profitability (Bikker & Vervliet, 2017). . Due to the
inability for banks to control the level of interest rate they focus on interest rate trend. Banks
manage and hedge against interest rate exposures in other to stabilize profit. Central bank’s
control interest rate has a major influence on commercial banks profitability. Exiting literature as
established relationships between interest rate changes and banks profitability. Nevertheless, the
effect of changes in interest rate on banks net interest margin (NIM) and profitability varies by
bank and country.

Borio et al. (2015), researched on the impact of monetary policy on banks profitability, by
analyzing interest rate effect on banks net interest income, non‐interest income, and also its
overall profitability measured by return on assets, they concluded that higher short-term interest
increase banks net interest income by raising banks interest margin. In their research on bank
profitability and risk taking under low interest rate, Bikker and Vervliet (2017), came to a
conclusion that low interest rate affects banks’ net interest margin and also, overall profitability
is impaired as a its result of the low interest rate. When analyzing interest rate, yield curve and
bank profitability on emerging markets, Aydemir and Ovenc (2016) showed that monetary
policy affect the banks profit and that short-term interest rate and the slope of the yield curve
have a negative impact on bank profits in the short run but has a positive impact in the long run.
(Hayo et al., 2018) in estimating the monetary policy interest rate to performance sensitivity of
European banking sector concluded that banks benefits from interest rate increase in a low
interest policy. Similarly, Genay and Podjasek (2014) showed that US banks are affected by low
interest rates in the long run through a narrower spread. Therefore, interest rate in monetary
policy influence the bank profitability, since it is a conventional knowledge that banks
profitability is a direct measure of a banks’ financial stability and soundness. It can be implied
that interest rate changes influence bank soundness and safety.

It is observed that long-term and short-interest rate, also yield curve has a significant impact on
banks net interest margin NIM, in other to ensure profitability banks aim to keep a higher
positive net interest margin as interest rate changes. The concept of net interest margin is the
difference between net interest revenue and interest expense (net interest income) divided by the
banks earning asset. Chaudron (2016) Concluded that low interest rate have a significant impact
on banks’ net interest margin and its impact is significantly greater than interest income than on
interest expense, also they found out that banks with shorter maturity in its balance sheet are
more affected than banks with longer maturity in its balance sheet. In other words, a fall in
interest rate will reduce interest income because there will be a decline in the revenues from
loans and other investment and the interest revenue will not be able to cover the interest expense
arising from deposits as the interest on assets and interest on liabilities do not move at the same
speed. Thus, profits through net interest margin are affected by the changes that arises due to
policy induced interest rates.

In analyzing the influence of short-term and long-term interest rate on net interest margin,
Albertazzi and Gambacorta (2009) used the aggregate income statement of 10 OECD countries
to show that that short-term and long-term rates have a differential impact on bank margins with
a more significant effect in the long-run. Similarly, Alessandri and Nelson (2015) focused on the
United Kingdom banking sector and suggested that in the higher interest rate have clear
significant positive effect on banks net interest margin and profitability in the long run. Also,
Busch and Memmel (2017), in their studies of German market during low interest rate period,
showed small but positive effect of long term rates in bank profit margins. However, Kerbl and
Sigmund (2016) showed the negative impact of low interest rate and a flat yield curve on
Austrian bank’s net interest margins. In the case of emerging counties, the findings of (Aydemir
& Ovenc, 2016) showed that emerging countries are significantly more sensitive to interest rate
that other developed countries.

Over the years, countries has adapted the negative interest rate policy especially in European
countries, the aim of this policy is to encourage banks to increase their credit supply and ensure
economic stability. However this negative interest rate policies has either a negative or positive
impact on banks performance and stability. Thus it important for the commercial bank to protect
their profit and performance to fall of interest rates, it can be hedged either by increasing the
credit supply to mitigate the decline in the volume of interest margins, by reducing operating cost
or by redirecting income from interest asset towards non- interest sources (Boungou & Hubert,
2020).

In studying the channels of bank response to negative interest rate, Boungou & Hubert, (2020)
showed that, negative interest policy leads to a decline in net interest income that can be hedged
against by increasing net non -income interest. They provided that the negative impact was as a
result of interest rate on deposit, commercial banks are reluctant to charge negative interest rate
on customer’s deposit and they mitigate the shock of downward interest rate by reducing interest
paid on non-customer deposits liabilities such as borrowed funds and reducing operating
expenses.

Changes in interest rate do not affect net interest margin alone but also its return on asset, its
equity and stock. Landier et al. (2013) found that US banks that positively exposed to interest
rate risk and their asset are more sensitive than their liabilities. Altavilla et al. (2018) concluded
with a positive impact of low rates on European banks’ return on asset (ROA).

In the study of interest rate and equity valuation, English et al. (2012), showed that policy
induced shocks to the level and slope of yield curve has negative effect in the bank equity values.
Also, they concluded that interest rate affect banks’ profits through its net interest income and an
increase in the level of interest rate lead to a significant increase in the net income margin. The
banks’ stock is also affected by the changes in interest rate, Ampudia and den Heuvel (2022)
found that short term rate shocks on bank stock price depends on changes in in the interest rate.
The central bank in control of interest rate has a significant impact in the bank stock price and
performance, when implementing interest rate policy the central bank needs to be cautious
because a negative interest rate can affect and harm the stock price of bank, in other words banks
stock prices are usually at a disadvantage when there is a negative interest rate. Bats et al.(2022)
concluded that negative interest rate affect the bank stock price and that an unplanned downward
shift in the yield curve as a result of the announcement of monetary policy on negative interest
rate can dramatically reduce the bank stock price and with a downward drop in the yield curve
has a great impact in the bank performance. In a negative interest rate environment, the banks’
stocks is at a disadvantage compared to general stock prices. Also, Bats et al. (2022) concluded
that the bank performance will be great harmed when the period of negative interest rate
prolongs and similarly, the financial stability will be affected because the banks may reduce
lending and since lending rate are more elastic than deposit rate, a decline in credit rate will
decrease the net interest margin. (Boungou & Hubert, 2020) suggested that large banks with
higher deposits and higher lending base are more affected by interest rate risk particularly,
negative interest rate policy. However, (Dang & Huynh, 2022) showed that banks who has more
yield in non-interest income and diversify into various income sources are able to mitigate
against monetary policy specifically interest rates changes,
In another instance, Interest rate policy also has an effect in banks’ portfolio risk management,
this is because as the interest rate risk decreases, the banks opportunity cost reduces and this will
make the bank to redirect its portfolio into risky assets in other to stabilize profits. (Lojak et al.,
2023) concludes that when interest rate approaches zero the banks’ capital structure moves from
good to a poor capitalization beyond the capital requirement and the same time increases risk
premium.

Conclusion

The central bank control interest rates through the implementation of monetary policies to ensure
and promote a stable economy. As it has been established that banks do not control the level of
interest rate changes, instead they follow the trend and try to mitigate the risk that comes with the
changes interest rate. Commercial banks aim to protect their profits against any risks that may
arise due to interest rate changes, it can be said that most risks that the banks takes are influenced
by interest rate policies. Interest rate affect the banks profit and performance of a bank, and
profitability is a major determinant of a sound and stable bank.

As reviewed in this paper, the central bank through its negative interest rate monetary policy can
lead to a decline in the net interest income of a bank, its net interest margin and can harm the
banks’ stock price which can also indicates its equity value.

Similarly, various researches concluded that, long and short term Interest rate affect the banks’
profits, it was concluded that short term interest rate and a downward slopping yield curve has a
negative impact on banks’ profits in the short run but a positive impact in the long run. The
effect of interest rate on net interest income is important for the banks because a fall in its net
interest income can harm the bank profits and in the long run can lead to a bank been financially
unstable. Although, interest rate affect bank profitability, its impact is not instant as they adjust
their response to changes interest rate and continue to make adjustments depending how long
interest rate policy changes. Therefore it is important for a bank to mitigate interest rate risk to
ensure and maintain overall profitability in other to ensure a stable and sound bank.
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