Simple banking: profitability and the yield curve

Working papers set out research in progress by our staff, with the aim of encouraging comments and debate.
Published on 21 June 2012

Working Paper No. 452
By Piergiorgio Alessandri and Benjamin Nelson 

How does bank profitability vary with interest rates? We present a model of a monopolistically competitive bank subject to repricing frictions, and test the model’s predictions using a unique panel data set on UK banks. We find evidence that large banks retain a residual exposure to interest rates, even after accounting for hedging activity operating through the trading book. In the long run, both level and slope of the yield curve contribute positively to profitability. In the short run, however, increases in market rates compress interest margins, consistent with the presence of non negligible loan pricing frictions.

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