Concerns prevail that a policy rate cut could weaken bank profitability and trigger financial instability. However, banks can sustain relatively high net interest margins with little fluctuation despite a rate cut owing to their dominant position in the deposit market and ability to adjust loan maturity.
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● Author
- HWANG Sunjoo, Fellow at KDI

● Go to a related report
- Impact of a Policy Rate Cut on Bank Profitability and Financial Stability

It is widely speculated that interest rates will fall if the Bank of Korea lowers the policy rate.

So, does this mean that the profitability of banks will also fall?

A recent analysis revealed that, despite the volatility in the US policy rate during the past 60 years, there have been no notable changes in the profitability of US banks.

Then, how have they been left unscathed?

A bank’s profit is represented by the gap between the lending rate and deposit rate.

The interest rates typically moved in line with the policy rate, but the deposit rate fell by a smaller margin than the cuts in the policy rate.

The loan interest rate also fell by the same small margin because banks had balanced the shares of long-term loan and short-term loan, where the long-term loan rate does not change for a short period of time while the short-term loan rate changes vis-a-vis the policy rate.

The banks were able to adjust their deposit rates and the shares of long-term and short-term loans thanks to their dominance in the deposit market.

This dominance is owed to two factors.

The first is weak market competition as only a small number of approved banks can do business.

The second is that, regardless of the interest rate, there is little difficulty in securing new deposits because people always need deposit accounts to save and withdraw their money.

Then, has the policy rate affected the net profit of banks in Korea?

KDI conducts an empirical analysis based on data for the last 20 years and finds that the correlation between the two is almost negligible.

In fact, on a 1%p drop in the call rate, which stays almost the same as the policy rate, the deposit rate and loan rate both fall by a mere 0.5%p.

Specifically, thanks to their market dominance, banks do not suffer any major losses in their profit from a policy rate cute because the loan rate and deposit rate fall by the same margin.

This analysis reveals that the policy rate does not significantly affect bank profitability.

As such, there is no reason to be apprehensive about a cut in the policy rate diminishing bank profitability, and ultimately, destabilizing the entire financial system.

However, one thing that should be noted is that a rate cut due to other destabilizing factors such as household debt or external debt warrants careful consideration.