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KDI Policy Forum
Impact of a Policy Rate Cut on Bank Profitability and Financial Stability

August 05, 2020

  • Author HWANG.Sunjoo
  • Series No. KDI Policy Forum No. 280 (2020-05), eng.
  • Language English
PDF
KDI Policy Forum
Impact of a Policy Rate Cut on Bank Profitability and Financial Stability

August 05, 2020

  • Author HWANG.Sunjoo
  • Series No. No. 280 (2020-05), eng.
  • Language English
PDF
    1. Concerns over Bank Profitability

    2. Banks’ Market Dominance and Ability to Determine Loan Maturity Defend Against Profit Loss due to a Base Rate Cut

    3. Empirically, a Base Rate Cut Does Not Deteriorate Bank Profitability

    4. Policy Implications
KDI Report VOD
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.
■ 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.

- By virtue of their market dominance, banks set their deposit rates below the base rate by a fixed percentage, and as such, the former falls within a narrower range than the latter.

- Because deposit rates are little exposed to base rate fluctuations, banks are able to increase their share of long-term loans which are unaffected by short-term rate changes. This means that lending rates also fall by a smaller margin.

- An empirical analysis found that a 1%p change in the call rate, which moves in line with the base rate, adjusts the deposit and lending rates by 0.53%p and 0.58%p, respectively, indicating that the fluctuation (0.05%p) in the net interest margin is statistically insignificant.

■ Therefore, the possibility of financial instability due to a deterioration in bank profitability on a rate cut by the central bank should not be deemed as a constraint.
 
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Office of Global Economy
Providing Economic Forecast and Macroeconomic Policy Direction, the Groundwork for a Brighter Future

The Department of Macroeconomics is conducting researches on the macro economy and macroeconomic policy, particularly focusing on suggesting the analysis of macroeconomic trends and current status of the economy at home and abroad, the economic forecast, and the policy direction of the macro economy. The Department is also in charge of establishing, sustaining and maintaining various econometric models, based on which it analyses policy effects and develops a long-term economic forecast.

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