A macroprudential look into the risk-return framework of banks’ profitability

Ensuring the resilience of the financial system implies managing a trade-off between expected bank profitability and tail risk in bank returns. To describe this trade-off, we estimate a dynamic quantile regression model using bank-level data for Portugal that links future bank profitability to the current cyclical systemic risk environment net of the prevailing level of capital-based resilience (residual cyclical systemic risk). We find that an increase in residual cyclical systemic risk negatively affects the conditional distribution of bank profitability at the medium-term projection horizons, confirming the findings in the literature. We propose a novel calibration rule for the countercyclical capital buffer (CCyB), which is flexible enough to accommodate different preferences of the policymaker and factors in the prevailing levels of cyclical systemic risk and capital-based resilience. We illustrate the operationalisation of this rule under different assumptions for the policymaker preferences and show how tightening capital requirements alters the risk-return relationship of future profitability in the banking sector. We find evidence that increasing the CCyB rate improves the outlook for medium-term downside risk in bank profitability and worsens the outlook for short-term expected profitability, stressing the tradeoff faced by the policymaker when deploying policy instruments and the misalignment in the horizons at which costs and benefits take place.