How Do High Interest Rates Affect Banks: The Roles of Loan Losses and Macroprudential Policy

This paper examines empirically how the effect of interest rates on the three components of bank profits – loan loss provisions, net interest margin, and non-interest income – varies depending on bank characteristics and the macroprudential policy environment. A new finding is that higher interest rates lead to larger loan loss provisions for banks offering flexible-rate loans, but that this effect is attenuated when macroprudential borrower-based measures have been tight in preceding years. Tighter macroprudential settings also reduce the effect of higher unemployment on loan loss provisions recorded by banks, and thereby the negative impact of unemployment on profitability. Moreover, we find significant heterogeneity across banks: banks with strong risk appetite that extend loans at flexible rates are adversely affected by higher interest rates, as the effect on loan losses dominates the effect on the interest margin, while the profitability of other banks benefits on average from higher interest rates.