The Impact of Interest Rate Risk on Bank LendingToni Beutler, Robert Bichsel, Adrian Bruhin and Jayson Danton

SNB Working Papers 4/2017

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The Impact of Interest Rate Riskon Bank Lending

Toni Beutler, Robert Bichsel, Adrian Bruhin and Jayson Danton

January 16, 2017

Working Paper

Abstract

In this paper, we empirically analyze the transmission of realized interest rate risk the gain or loss in a

banks economic capital caused by movements in interest rates to bank lending. We exploit a unique panel

data set that contains supervisory information on the repricing maturity profiles of Swiss banks and provides

us with an individual measure of interest rate risk exposure net of hedging. Our analysis yields two main

results. First, the impact of an interest rate shock on bank lending significantly depends on the individual

exposure to interest rate risk. The higher a banks exposure to interest rate risk, the higher the impact of

an interest rate shock on its lending. Our estimates indicate that a year after a permanent 1 percentage

point upward shock in nominal interest rates, the average bank in 2013Q3 would, ceteris paribus, reduce its

cumulative loan growth by approximately 300 basis points. An estimated 12.5% of the impact would result

from realized interest rate risk weakening the banks economic capital. Second, bank lending appears to be

mainly driven by capital rather than liquidity, suggesting that a higher capitalized banking system can better

shield its creditors from shocks in interest rates.

Disclaimer: The views, opinions, findings, and conclusions or recommendations expressed in this paper are strictly thoseof the author(s). They do not necessarily reflect the views of the Swiss National Bank. The SNB takes no responsibility

for any errors or omissions in, or for the correctness of, the information contained in this paper.

JEL classification: E44, E51, E52, G21Keywords: Interest Rate Risk; Bank Lending; Monetary Policy Transmission

Corresponding Author: Adrian Bruhin, University of Lausanne, Faculty of Business and Economics (HEC Lausanne),1015 Lausanne, Switzerland; email: adrian.bruhin@unil.ch; phone: +41 (0)21 692 34 86

Swiss National Bank, Financial Stability, 3001 Bern, SwitzerlandUniversity of Lausanne, Faculty of Business and Economics (HEC Lausanne), 1015 Lausanne, Switzerland

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Acknowledgements

We are grateful for the insightful comments from an anonymous referee, Stefanie Behncke,Frederic Boissay, Martin Brown, Peter Hoerdahl, Bo Honor, Cathrine Koch, Ulf Lewrick,Pius Matter, Cyril Monnet, Davy Reinhard, Jean-Paul Renne, Bertrand Rime, Mark Watson,and the members of the financial stability unit of the Swiss National Bank. We would alsolike to thank the participants at the seminar of the Bank for International Settlements (BIS), the2016 Annual Congress of the Swiss Society of Economics and Statistics, the Brownbag Sem-inar Series of the Swiss National Bank (SNB), and the Macroworkshop and Research Days ofthe University of Lausanne. We thank Elio Bolliger for his excellent research assistance. Anyerrors and/or omissions are solely our own.

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1 IntroductionBanks are exposed to adverse movements in interest rates because on average, rates on theirlong, fixed-term assets are locked in for longer than rates on their liabilities. When the generallevel of interest rates rises, banks typically experience a loss in economic value because thevalue of assets decreases more than the value of liabilities.

One important question in that context is the extent to which realized interest rate risk ex-posure i.e., the gain or loss in a banks economic capital attributable to movements in interestrates affects bank lending. This question is particularly relevant in the current environmentof prolonged low nominal interest rates in which banks have substantially increased their in-terest risk exposure (Turner, 2013; SNB, 2014, 2015). For instance, findings by Hanson andStein (2015) suggest that as nominal interest rates declined, banks have rebalanced their assetholdings toward longer maturities to prevent their portfolios overall yield from decreasing toomuch.

The theoretical literature on the transmission of monetary policy postulates that interest raterisk exposure makes bank lending more sensitive to changes in nominal interest rates (Van denHeuvel, 2002, 2007). The postulated mechanism contains the following intuition: If nominalinterest rates rise, the resulting loss depletes a banks economic capital and brings it closer toregulatory or market requirements. In such a situation, the banks ability to restore its requiredcapital level by issuing new equity is limited because asymmetric information between exist-ing and potential new shareholders makes equity issuances costly (Myers and Majluf, 1984;Kashyap and Stein, 1995; Myers, 2001). Consequently, the bank reduces its lending to remainin compliance with capital requirements imposed by regulators or market participants.

Empirically testing how realized interest rate risk exposure affects bank lending is diffi-cult for two reasons. First, necessary information about interest rate sensitive balance sheetpositions and the corresponding repricing maturities is often unavailable. Second, detailedinformation about the positions used for hedging against interest rate risk is typically not pub-licly available. Therefore, constructing a measure of individual interest rate risk exposure netof hedging is often infeasible based on publicly available information.

In this paper, we address these issues by exploiting a quarterly panel data set comprisingsupervisory information on Swiss banks between 2001Q2 and 2013Q3. Our sample comprisesdomestically focused commercial banks whose business model results in interest rate risk act-ing as a major risk factor. The data set provides us with an individual measure of interestrate risk exposure that directly relies on each banks repricing maturity profile. In a supervi-sory survey, each bank reports its interest rate-sensitive cash flows separated by their repricingmaturities, i.e., the remaining time until the interest rate on the underlying position is reset.The repricing mismatch implied by these cash flows yields the individual measure of inter-est rate risk exposure. This measure corresponds to the adjustment in the banks economicvalue in response to a permanent 1 percentage point (pp) change in nominal interest rates over

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all maturities. One major advantage of this measure is that it reflects individual interest raterisk exposure net of hedging because the banks reported cash flows consider eventual hedgingpositions.

We apply a dynamic panel data model that relates bank loan growth to interest rate riskexposure and various individual and macroeconomic control variables. The model, inspired byKashyap and Stein (1995, 2000) and Gambacorta and Mistrulli (2004), enables us to estimatethe most important channels through which bank loan growth responds to changes in nominalinterest rates. It also allows us to estimate the sensitivity of this response to individual interestrate risk exposure.

The analysis yields two main results. First, changes in economic capital, as measured byrealized interest rate risk exposure, affect bank lending. The estimated effects of a given shockin interest rates are initially small and not statistically significant but increase over the next fourquarters, eventually becoming highly significant. For instance, in response to a permanent 1 ppincrease in nominal interest rates, the average bank in 2013Q3 would, ceteris paribus, reduceits predicted quarter-on-quarter loan growth rate by 46 basis points (bp) immediately after theshock and reduce its cumulative loan growth after one year by approximately 300 bp. Theimpact of an interest rate shock on bank lending significantly depends on individual exposureto interest rate risk. The higher a banks exposure to interest rate risk, the higher the impact of aninterest rate shock on its lending. For e