Global Financial Cycles, Portfolio Frictions, and Bank Profitability: Evidence from Small Open Economies

This paper examines how global financial conditions shape bank profitability in small, open, and externally dependent economies. Using bank-level data for Caribbean and Central American countries and System GMM estimation, we assess the impact of U.S. long-term interest rates on two profitability measures: return on equity (ROE) and return on assets (ROA). We find that U.S. Treasury yields have a strong positive effect on ROE, while the response of ROA is considerably weaker. This asymmetric transmission is consistent with portfolio and balance-sheet frictions that constrain balance-sheet adjustment and may limit asset expansion and portfolio reallocation, with global yield movements operating as an indicator of external financial conditions within the global financial cycle rather than as a purely isolated U.S.-specific monetary shock. Using a leverage-based benchmark, we show that the magnitude of the ROE response cannot be explained by accounting mechanics alone, supporting the interpretation that the ROE-ROA divergence reflects constrained adjustment rather than purely mechanical leverage amplification. The findings indicate that equity-based profitability measures are more informative indicators of external financial transmission, with implications for international financial analysis and financial stability monitoring in small open economies.