Prolonged Low Interest Rates and Banking Stability

Banks in developed countries share a common concern that prolonged low nominal interest rates may pose a threat to their business, as the level of nominal interest rates is often positively correlated with bank profits in the data. It is not well understood, however, how low nominal interest rates impact bank profits and what they imply for banking stability. To address these issues, this study theoretically explores how the level of nominal interest rates affects bank profits and banking stability in the long run by extending a model of bank runs constructed by Gertler and Kiyotaki (American Economic Review, 2015). The model, calibrated to Japan and other developed countries, makes three predictions: (1) low interest rates do indeed reduce bank profits by compressing the deposit spread; (2) due to the presence of the effective lower bound of the policy rate and a slow recovery of bank net worth after a run, low interest rates bring the economy closer to a state where a bank run equilibrium can exist; (3) although there are quantitative differences across countries, a decline in nominal interest rates does not necessarily bring the economy to a state with a bank run equilibrium on its own, except for in severe cases where the TFP growth rate or the target inflation rate falls below zero.