Banks' Search for Yield in the Low Interest Rate Environment: A Tale of Regulatory Adaptation 
Banks are compensated primarily through the net interest margin (NIM), which is the difference between the interest earned on their investments and the interest paid to their depositors and other creditors. In the low interest rate environment that has persisted since the Great Recession, banks can no longer lower the short-term rates paid to their depositors to below the market rate, so to obtain a higher NIM they must search for higher current yields on assets by taking on more credit risk or non-credit risks (such as interest rate risk). For any given gain in current yield, some types of potential future losses associated with non-credit risks, such as mark-to-market losses due to yield increases, can be avoided with accounting treatments. A simple model shows that a bank's incentive to take on risks for which potential future losses can be managed is countercyclical, especially if a bank is capital constrained or used to have a wider NIM in the past. The loan losses suffered by many banks due to the financial crisis, coupled with the low interest rate environment during the slow recovery, renders it particularly attractive for banks to reach for yield by taking on non-credit risks. This study thus focuses on banks' exposure to interest rate risk through a maturity mismatch between assets and liabilities since the Great Recession.
In the United States, a key feature of the post-crisis period has been the wide-ranging regulatory and supervisory reforms enacted to make the nation's banking system safer. Those banking institutions deemed to pose a systemic risk, which are generally the largest (with total assets of $250 billion or more) are now subject to more stringent and extra regulatory requirements, such as the advanced approaches capital rule. In particular, the removal of the so-called accumulated-other-comprehensive-income (AOCI) filter, which used to prevent unrealized gains/losses on the fair value of available-for-sale (AFS) securities from changing the amount of regulatory capital, likely has had the most pronounced disparate impact on incentives to take on more interest rate risk in order to earn a higher NIM. Since this filter was removed only for banks subject to the advanced approaches capital rule, smaller banks presumably have had greater latitude to reach for yield through greater exposure to interest rate risk over the post-crisis years.
This study uses Call Report data and difference-in-differences analysis to examine whether, in the post-crisis environment, banks have reached for yield by taking on more interest rate risk, subject to the size-dependent enhancement of regulatory restraints after the crisis. The analysis thus places bank holding companies (BHCs) into one of four groups, depending on the post-crisis regulatory treatment: 1) the largest BHCs (those subject to the advanced approaches capital rule), mostly those with more than $250 billion in assets, 2) those BHCs with assets between $50 and $250 billion, 3) those BHCs with assets above $10 billion but less than $50 billion, and 4) those BHCs with assets under $10 billion. The sample period runs from 1997:Q2 through 2015:Q4; 2007:Q2 marks the start of the financial crisis.
Key Findings
- The systematic difference in the post-crisis maturity change for assets held by the largest versus the smallest BHCs suggests that the smallest BHCs, because they are subject to less post-crisis regulatory constraints, were able to search for yield more aggressively by raising their maturity mismatch than was the case for the largest BHCs.
- Before the 2008 crisis, the largest BHCs substantially increased their asset maturity from 3 to 5 years, mostly during the 2001 recession and early into the recovery afterward. Within a year of the onset of Great Recession, the largest BHCs reduced their average maturity to four years, which has remained steady since then. In contrast, prior to the 2008 crisis, the smallest BHCs kept their asset maturity within a narrow range, but afterwards have consistently lengthened it from 3.5 years to 5 years, surpassing the asset maturity of the largest BHCs since 2012
- There is fairly robust evidence that the BHCs that had a higher NIM before the crisis were more apt to increase their maturity mismatch, possibly because a bank's current performance is benchmarked to its past performance. There is somewhat weaker evidence that loan losses suffered during the recession, or high exposure to residential mortgages before the crisis, also seems to predispose a bank toward taking on more maturity mismatch.
- In the quarters after the taper tantrum shock in May 2013, when some banks experienced nontrivial unexpected losses on the fair value of their AFS securities, BHCs in the two largest size classes increased their share of securities classified as held-to-maturity (HTM), as this accounting treatment avoids the need to recognize any future fluctuations in the fair value of these assets. This change in the composition of a bank's securities portfolio by accounting method contrasts with past practices, as historically the smallest BHCs used to consistently classify a higher fraction of their securities holdings as HTM. The timing of the relative increase in securities accounted as HTM coincides not only with the taper tantrum, but also with the removal of the AOCI filter.
Implications
In the aftermath of the financial crisis, many central banks experimented with unconventional policies to promote economic recovery, such as lowering long-term interest rates through large-scale asset purchases known as quantitative easing (QE). The post-crisis regulatory changes, on the other hand, have reduced the largest BHCs' ability or willingness to hold long-term assets. The new regulatory constraints may have rendered the unconventional monetary policies less effective than otherwise might have been the case, since the largest BHCs account for over 75 percent of the U.S. banking sector's overall assets. More generally, the risk-based capital requirement gives banks an incentive to shift their portfolios from loans to securities during downturns. One solution to mitigate such potential incompatibility between monetary policy and regulatory policy objectives is to enact a countercyclical capital requirement, which should damp the cyclicality of lending. Going forward, as short-term interest rates rise with the gradual return to a neutral monetary policy stance, the banks that have opted to hold a higher share of long-dated assets will face a reduction on their NIM, which may in fact incentivize them to lend to more risky borrowers to maintain their NIM. If, however, the fair value losses as a result of the rising interest rates reduce a bank's regulatory capital, then it could constrain a bank's capacity to lend. More research is needed to better understand the cyclical dynamics of bank risk taking and the impact on credit supply.
Abstract
This paper examines whether the low interest rate environment that has prevailed since the Great Recession has compelled banks to reach for yield. It is important to recognize that banks can take on a variety of risks that offer higher yields today but incur different forms of future losses. Some losses, such as mark-to-market losses due to yield increases, can be avoided with accounting treatments whereas others, chiefly credit losses, cannot. A simple model shows that a bank's incentive to take on risks for which potential future losses can be managed, such as interest rate risk, is countercyclical, especially if a bank is capital constrained. This study thus focuses on a bank's exposure to interest rate risk through a maturity mismatch between its assets and liabilities. It finds evidence that the banks that faced less enhanced regulation after the financial crisis, especially those institutions used to having a higher net interest margin before the crisis, took on assets with longer maturities or prepayment risk, even while their source of funding shifted toward more transaction and saving deposits as a result of the near zero short-term interest rates. In contrast, those banks designated as systematically important and thus subjected to expanded post-crisis regulations have substantially shortened the average maturity of their assets since the crisis. There is some evidence that greater maturity mismatch is slightly more associated with a higher net interest margin during the post-crisis years. After the taper tantrum in 2013, these two groups of banks also adjusted their securities holdings in different ways, consistent with the differential regulatory accounting treatment.