The Impact of Interest Rate on Bank Productivity - Essay Example

 The impact of interest rate on bank productivity Introduction: Unexpected movements in macro-economic variables can make a banking institution structurally vulnerable to financial crisis, especially with the liberalization of the financial markets. In view of government regulations mandating balances and the percentages of liquid assets that can be invested, banks tend to maintain balance sheets where all of its transactions are not recorded, especially derivative activities. As a result, when there are sudden shifts in interest rates, there could be sharp losses accruing to banks, while at the same time, there may be inadequate liquid balances available to bear such shifts in rates. This can cause a crisis situation in banks, such as the crisis in the financial markets of south east Asia which occurred in 1997. Slight changes in interest rates can impact significantly upon a bank’s losses or profits, since bank investments are largely securities and investment directed, with such investments being subjected to the vagaries of interest rate volatility. Aim and objective of this study: Research conclusively suggests that exchange rates and interest rates play a significant role in the position of bank balance sheets. For example, if a bank has a higher proportion of liabilities as compared to assets, then an increase in interest rates creates a negative financial position for the bank. The market value of assets falls more than liabilities and this affects the net interest margins and cash flows. A deterioration of the bank balance sheet through a contraction in capital can impact upon the role of the bank as a financial intermediary and render it incapable of performing its role. When interest rates rise, then with cash flow of borrowers being reduced, they can pose a greater credit risk to the banks. This can also result in damages to the quality of bank assets in emerging markets in developing countries, since they will not be in as favorable a position when liabilities are over leveraged. The research question that is proposed to be examined in this study is: How do interest rates impact upon bank productivity? Methodology: This study seeks to examine the impact of interest rate fluctuations and the risks that exposure to such fluctuations can pose to banks. The impact of interest rates on bank productivity will be the focus of this report and all aspects whereby interest rates play a role in bank productivity will be taken into consideration. This study will first carry out an extensive literature review, which will form the secondary data for this study. The primary data will be drawn from annual reports of banks that will provide a picture of bank productivity and associated with information on changing interest rates, in order to examine any trends that may be evident. The study will use a primarily quantitative method since an assessment of bank productivity will require numerical analyses using the financial reports; however qualitative analysis will also be applied in comparing fluctuations in interest rates. Hence a mixed methods approach is proposed to be use din this study. Literature Review: A bank’s productivity and performance can be measured through the use of various indices, one among which is various kinds of accounting ratios. For example, Hassan and Adnan (1999) assess bank profitability on the basis of ROA (Return on Asset) and ROE (Return of Equity) ratios, which are indicators that measure managerial efficiency. The ROA is the net earnings per unit of a given asset; an indicator of how a bank can convert that asset into net earnings. It is calculated as the ratio of the profit after tax to the total asset and a higher ratio value indicates a higher level of ability, thus providing an indication of better performance. ROE, or the Return of Equity is the net earnings per dollar of equity capital. It is calculated as the ratio of the profit after tax to the equity capital. A higher value of this ratio indicates a better level of managerial performance and higher profitability levels, thereby providing an indication of good bank productivity. Samad and Hussein (no date) have evaluated the intertemporal and interbank performance of Islamic Bank in Malaysia to assess the bank’s productivity. They have measured bank performance over two successive periods, as well as specifically compared performance with two other banks – Bank Pertanian and the Bank Perwira Affin, as well as a comparison with the banking industry comprising eight other banks on various financial ratios. One of these is a liquidity ratio, since an imbalance between withdrawals and deposits could pose a liquidity threat to the bank. The different kinds of liquidity ratios they have assessed in their study are (a) cash deposit ratio or the ratio of liquid cash to deposits (b) Loan deposit ratio or the ratio of loans advanced by the bank to the deposits received (c) current ratio – or the ratio of current assets to current liabilities. (d) current asset ratio – which is the ratio of current assets to the total assets of a bank. Positive values for all these ratios except loan deposit ratio indicate a healthy bank position on liquidity. Additionally, they have also applied the profitability ratios as put forth by other researchers like Hassan and Adnan (1999) in comparing the performance of Islamic Bank with others. Lastly, Samad and Hussein (no date) have also assessed risk and solvency ratios such as (a) debt/equity ratio or the ratio of debt to equity capital (b) Debt to asset ratio or the ratio of debts to total assets (c) equity multiplier or the ratio of total assets to the share capital and the loan to deposit ratio or ratio of loans to deposit measures. A higher ratio in all of these measures indicates that the bank is involved in risky enterprises with the potential for illiquidity. They have also applied some ratios that are specific to the Muslim situation, such as (a) long term loan ratio or the ratio of long term loans to the total loans (b) Government bond investment ratio which is the ratio of deposits invested in government bonds to the total deposit and (c) Mudaraba-musharaka ratio or the ratio of mudaraba-musharaka (interest free) loans to the total loans of the bank. High ratios in all of these indicated a high level of bank commitment to long term development and community, as well as good liquidity. Thus, in terms of interest rates and how they may affect bank productivity, the article by Samad and Hussein (no date) points out that interest rates may not be applied at all in Muslim banks and they function differently from conventional banks, because interest or “riba” is prohibited by Islam. This has however affected the profitability of the bank, because the scope for its investments in stocks and securities is considerably reduced because of these religious constraints. The bank is able to invest only in assets such as Government bonds, which do not yield such high returns. But the positive aspects of not investing in securities whose values are determined by interest rates is that the investments are subject to less risk. The bank is also able to maintain higher liquidity levels because it must provide guarantees for the depositors’ deposits; as a result it has a better capacity to absorb shocks.(Samad and Hussein, p 5).In this study, the authors also carried out a survey among bank personnel as well as members of the public, which revealed that interest free loans are not popular because other means of financing are more profitable and less risky. Short-term rates affect banking behavior by increasing the level of risk taking. For example, Ip and Hilsenrath (2007) have argued that the low interest rates prevailing during the 2002-2005 period created the kind of conditions that prompted excessive risk taking behavior. They point out that with the collapse of the savings and loan industry in the U.S. in the 1980s coupled with the Asian Financial crisis of 1997 and the bursting of the IT stock market bubble, created crisis like conditions that prompted the Federal Government to step in to address the situation and prevent a severe economic downturn by lowering interest rates. This was the spur that created changes within the banking system. While the objective of the federal Government was to improve the economy by making credit cheap through the cutting of interest rates, the result has been a sharp rise in risk taking behavior by banks. Ip and Hilsenrath (2007) point out that there has been an increase in leveraged buyouts, hedge funds, housing loans and private equity firms that are borrowing heavily in order to make big bets. The low interest rates were intended to stimulate the economy and enhance consumer spending and the damaging effects of inflation have certainly been contained by this move of the Government, but it has also produced other long term effects on the economy. One is the sub prime crisis, with low interest rates prompting banks and other lenders to offer loans to customers with questionable credit histories adjustable rate mortgages with low introductory rates. It is non payment of these mortgages that has produced the current sub prime crisis. Another risk posed by low interest rates is the threat of deflation, where prices generally remain low and this hampers job creation and business investment and makes it harder to repay debts. Ip and Hilsenrath (2007) have also highlighted the views of experts who feel that short term interest rates in the United States were kept low for too long a period, which over-stimulated the housing market and caused the sub prime crisis. The authors have shown how increased regulation of banks after the earlier financial crises of the 1980s and 90s have propelled increased risk-taking behavior by unregulated entities. Banks in the United States are insured with FDIC and banks are also required to hold more capital as a precautionary measure to offset risky loans. Restricted lending activity by banks has brought other unregulated lenders into the playing field (Ip and Hilsenrath, 2007). These lenders financed themselves by borrowing from Wall Street credit lines and by securitizing their loans or distributing them across investors across the globe. Loans were sold to investors, as a result when buyers began defaulting on their loans, Wall Street credit lines to the lenders were cut and this has produced the current financial crisis. Although the maximum financial growth occurs when investors are free to take risks, low interest rates function as a spur to encourage banks and investors to engage in heavy risks. The structure of management of financial portfolios has resulted in the risks shifting from banks and to investors overseas who may have invested in complex securities. For instance, the risks arising out of non-repayment of housing loans due to the current sub prime crisis in the United States are now distributed across boundaries and markets to investors in several countries, so that a crisis in this area generates shock waves that spread across the globe.(Ip and Hilsenrath, 2007). The sub prime crisis is also duplicated in the business of leveraged buyouts, fuelled by generous credit markets arising out of low interest rates. Leveraged buyouts proved to be a profitable venture at first for investors, who were able to receive excellent returns on their investment. But just like the business of the sub prime mortgages, the initial success of this risky investment resulted in standards being lowered in identifying companies that could be targeted for the leveraged buyout, which in turn produces a higher percentage of default. As a result, banks in the United States are now saddled with commitments to lend out about $200 billion which were to be turned over to investors to distribute the risk among them, but with the reduced rates of return on such investments, investors are no longer coming forward and the banks are saddled with them. The volatility and changes in interest rates, as well as the term structure of interest rates can impact upon bank financial statements, since substantial portions of a bank’s financial holdings may be invested in assets and securities, which are sensitive to fluctuations in the market. Reiker (2007) has examined the recent trend for major banks in the United States to adopt a safe policy in terms of interest rates, in view of the negative consequences that can arise when banks engage in risk taking behavior, spurred on the gains they think they can achieve through short term fluctuations in interest rates. For example, in the year 2006, the position of J.P.Morgan Chase in the United States was liability sensitive; as a result a 1% interest rate cut would have resulted in loss in earnings of $21 million, while a 1% interest rate increase would have shifted its earnings upwards to $28 million. Thus, even a slight shift in interest rates can have a significant impact on the earnings or losses of a bank, depending upon how asset and liability sensitive it is. Cobos (2007) contends that banks must do a good job of matching assets and liabilities for their sensitivity to interest rates, those banks that fail to do this will suffer the brunt of losses resulting from fluctuations in interest rates. Interest rates influence the returns that can be obtained from securities that banks may choose to invest in to generate income. Cobos (2007) has demonstrated how inflation can play a role in the determination of interest rates by the Government. Low inflation associated with lower interest rates may represent conditions where investment in higher risk securities becomes more attractive for banks. Cobos (2007) suggest that conservative investors like banks may be better off orienting their investments into long term securities that are not so susceptible to interest rate volatility. Ideally, banks will fare well and show reasonably good earnings contributing to good productivity if their revenue streams are shifted away from interest sources of income to service charges and other non-interest incomes. Cukierman and Wachtel(1979) also corroborate Cobos’(2007) arguments about how inflation affects interest rates. They have argued that the Governments themselves can generate inflation to reduce interest rates Reiker (2007) in his study, has pointed out how many of the banks have chosen to refrain from trying to benefit from the short term changes in interest changes, because they need to balance out the potential advantages with the risks that are posed to them, as has occurred in the case of U.S. banks saddled with commitments as mentioned above (Ip and Hilsenrath, 2007), to provide funds for leveraged buyouts rife with risks that they can no longer pass on to investors. Banks in the United States did not position themselves to take advantage of declining interest rates, which were being predicted in 2007 (Rieker, 2007). While American banks earlier took steps to gain advantage of rising interest rates, financial history has shown that it does not pay to take interest rate risks, even when the direction of interest rate movement can be reliably predicted. As a result, many of the best-managed American banks are remaining neutral despite the variations in interest rates and the potential to benefit from them, because such movements essentially represent a risk. Stiefel Financial Corporation, Bank of America Corporation and Marshall and Ilsey Corporation are all banks that have remained neutral in the interest rate environment.(Rieker, 2007). As opposed to this, Fifth Third Bancorp, a Cincinnati financial company found that it was liability sensitive during a period when interest rates were rising. The result was that net interest margins were affected and net earnings from investments declined, leading to rancor and disappointment among investors. Exposure to changes in interest rates can thus be particularly disastrous for liability sensitive financial institutions. (Reiker, 2007). Another study that was conducted on Ukranian banks also corroborated the finding that in recent years, banks have tried to diversify their sources of revenue in order to improve their productivity. They rely less in income earned from interest rates, because interest rates are “volatile and cyclical” (Kyj and Isk, 2008: 386). The authors in this study divided the Ukranian banks that were the subject of the study into three separate categories based upon the duration for which they have existed (a) 2 to 5 years (b) 6 to 10 years and (c) 1 to 15 years. They have observed that on an overall basis, Ukranian banks fare poorly in comparison to other comparable countries. The EBRD (European Bank for reconstruction and Development) transition indicator for banking reform for most of these banks emerged at an average value of 1.9 which ranges from scores of 1 to 4 on the index. While these scores do suggest there has been significant liberalization in interest rates as well as credit liberalization, lower values on the index indicate interest rate ceilings while a score of 4 indicates a significant amount of lending to private enterprises. Their findings suggested that banks that had been in existence for more than 10 years had TEC (Technical Efficiency change), PTEC (Pure Technical Change) and SEC (Scale Efficiency Change) values that were significantly lower than the relatively newer banks, and this aspect could be attributed directly to the interest rates. Since interest rates have been decreasing in recent years and the number of credit worthy Ukranian companies are limited, this has resulted in a more competitive atmosphere that is saturated with bank services; as a result the authors suggest that new banks may need to be more efficient and be in a position to meet the stringent capital and financial ratios requirements if they are to survive ( Kyj and Isk, 2008: 386). Older banks on the other hand, have been accorded longer grace periods, so they have a greater degree of flexibility in their operations. This study appears to corroborate the findings by Reiker (2007) and Cobos(2007) suggesting that bank productivity is more likely to be enhanced if a greater proportion of revenues are sought from non interest income sources. Interest rate exposures can thus subject the banks to risks, especially in hedging of funds geared towards deriving benefit from interest rate volatility. In assessing the risks arising for banks out of interest rate exposure, I-Doun et al (2007) have compared the valuation ability of Black’s model to HJM models in terms of their efficiency in enhancing the hedging of interest rate exposure. Both these models are very close to each other in terms of theoretical point of view but demonstrate different behaviors when applied. These authors have examined how each of these models is useful within a risk management system, to measure, supervise and control interest rate risks, so that banks can anticipate and protect themselves against the risks arising out of interest rates. The test methodology used in this case for such testing was premised on (a) the capacity of the models to predict future option prices so that risk exposure can be correctly assessed (b) estimation of volatility parameters from these option prices rather than from the time series, because this allows for a better prediction of future volatility and (c) the use of implicit volatility, so that options across different strikes and maturities can be properly evaluated. The study used Eurodollar futures and options from January 1, 2000 to 31 December 2002. The findings in the study showed that when using the criteria of estimation of input data from the implied approach and the ex-post predictability of the model, the Black’s model outperforms two HJM models, namely the ABS and SQR models but does not similarly outperform the EXP model. The findings were also corroborated by using one week prediction patterns as well as alternative calibration strategies, both of which yielded similar results. However, while all the models demonstrated the existence of moneyness bias and maturity bias, the extent of bias is the least in the EXP model. On the basis of these findings the authors have concluded that the EXP model outperforms the other models in terms of predicting the risks likely to accrue from volatility in interest rates, thereby an inference can be drawn that this may be one of the best models for banks to use, so that they can benefit from interest rate volatility with lower levels of associated risk. Gao’s (2008) study focuses on banks in Japan and probes into the effect of the main bank’s equity-debt structure and the resultant effect on the performance of firms in Japan. Every firm has a main bank, which is its largest lender and also functions as a shareholder in the firm. As a result, this bank may function in the role of lender and shareholder simultaneously. The ratio of equity to debt of the main bank influences the rate of interest the bank may choose to charge, in order to further its own interests and improve its productivity. Gao argues that when a bank holds both debt and equity instead of pure debt, then being one of the largest shareholders, the bank becomes an insider and gains more control over the management of the firm. This allows it to be endowed with enormous bargaining power as compared to other shareholders and competing firms. Gao states that this power of the banks can be used in one of two ways. On the one hand, since Japanese banks hold both debt and equity, they can use their relationship with the client firms to reduce potential conflicts between creditors and equity holders. This might manifest for example, in the bank being less aggressive about rent extraction, which would produce greater profits for the firms. On the other hand, a bank may choose to focus upon its role as a substantial creditor and maximize its interests by seeking a more prominent role in the corporate governance of the firm without necessarily being concerned about whether or not the interests of the shareholders are being compromised. In his study, Gao has constructed an equity-debt index for 10,613 firms over a time frame from 1977 to 1987. The equity debt index was comprised of the market value of the equity stakes of the main banks as opposed to the debt structure in the firms of its clients. On the basis of this structure, they have classified their observations into three separate categories: (a) the main bank holds no equity stakes (b) the main bank holds some equity stakes but the bank’s loans or its debt claims are greater than the market value of its equity stakes and (c) the market value of the bank’s equity stakes are greater than its debt claims. Within the sample, 2444 firms came under category (a), 6095 under category (b) and 2094 under category (c). The findings in Gao’s (2008) study showed that on an overall basis, those firms with no main bank equity stakes tended to perform better than those with bank equity stakes. But among those firms with main bank equity stakes, the equity debt index impacts upon the firm’s performance. Since a main bank has such a close relationship with a firm, it is able to charge higher interest rates if debt claims are higher as compared to equity stakes, while on the other hand, they can pay out a higher dividend if their equity stakes are higher than their debt claims. Hahm (2004) has pointed out that in the case of long-term bank assets, the return on such assets may be stable, but the cost of these assets will rise with market interest rates. As a result, a fluctuation in market interest rates will reduce the net interest margin and decrease cash flows, thereby producing a negative impact on bank balance sheets. Such fluctuations may also reduce cash flows of non-financial borrowers, producing a corresponding increase in the borrower credit risk, which can indirectly produce a negative impact on bank balance sheets. Such a deterioration in the bank balance sheet means that its capital will also contract and the bank’s capacity to function as a lender will be diminished. This will negatively impact upon the productivity of the bank as well, because its financial ratios such as the debt equity ratio and equity multiplier mentioned above will not be favorable. In arriving at its investment decisions, banks are likely to take into account the expectations theory of the term structure of interest rates, states that both the short changes in the long rates and the long changes in the short rates conform to the long-short spreads. In demonstrating that this may not always be the case, McCallum (2005) argues that this is similar to the failure of the uncovered interest rate in foreign currency exchanges, where monetary policies of the Government may be the reason for such behavior to be evidenced. On this basis, he has shown that the failure of term structure of interest rates to conform to the expectations theory may similarly be the result of the monetary policies of the Government, which feature interest rate smoothing over the long-short period. Yong et al (2007) have taken up an investigation into the derivative activities of Asia pacific banks in order to assess whether the level of this activity is related to the perception of the markets on the extent of their interest rate risks. It is the derivative activities of bank, which have been the source of risks in the past and have also been associated with scandals. These authors have pointed out that derivative activities can be beneficial if they are used only for hedging purposes or in order to meet the needs of the customers. But when banks use these derivative activities for trading purposes, in an attempt to benefit from interest rate volatility, they are exposed to higher levels of risk especially because banks are significant users of derivatives but these transactions are not reflected on the bank’s balance sheets, and this may also be associated with a decline in productivity. In their study, Yong et al (2007) selected a list of locally incorporated banks in the Asia Pacific region, drawn from the websites of the banks in ten different countries, including Australia, Hong Kong, Malaysia and Japan. They gathered together the annual reports for 2002 for these banks and arrived at a total of 164 such reports, from which eighteen statements were eliminated because they did not disclose details of activity in derivates in the notes to the financial statements. An additional 36 banks were eliminated from the sample because data was not available from Datastream on their stock price. The authors then calculated the rate of return on bank stocks by using a mathematical formula that also incorporated the LTIR (returns on long term government bond index), STIR (3 month interest rates on Treasury Bills) as well as exchange rates of the local currency with the U.S. dollar. Based on the beta values obtained of the above variables, the association between the bank’s derivative activity and interest rate exposure was computed using another mathematical formula. The findings in this study showed that the use of derivatives appears to reduce the short term interest arte exposure of the banks but not the long term interest rate exposure. This findings supports the inference that banks are more likely to engage in speculative activity with derivatives, and since long term changes are more difficult to predict than short term ones, such speculative activity may present more of an interest rate exposure risk on a long term basis than on a short term one. Although changes in interest rates can pose a threat to banks in terms of exposing them to risk, Frankel et al (1991) have argued that the differences in risks experienced by banks in different countries cannot be examined only from the perspective of interest rates. The competitive environment for financial services is also dependent upon various other factors that have played a role in recent times. With the advent of technological advances, they point out that the cost of communications and information processing has been reduced. As a result, the relative cost of designing and writing out custom contracts for investors have been reduced, especially in the case of those transactions which involve foreign currency exchanges and interest rate options.(Frankel et al, 1991:258). In the United Kingdom for example, the role assigned to banks does not permit them to participate in a firm’s refinancing if there exists knowledge about the troubled nature of the firm. Such environmental factors can also play a role in the levels of regulation or exposure to risks arising out of interest rate exposure. Conclusions: Based upon the findings above, it may be concluded that there is an increasing trend for banks to reduce their level of interest based income generation. This is because attempts to derive profits from fluctuations in interest rates pose a risk that cannot always be correctly predicted. Interest rates play a significant role in terms of productivity, since the literature review also shows that Muslim banks which do not charge interest at all are not able to function as productively as traditional banks which use conventional income generation methods based on interest. Low interest rates can be a factor fuelling higher levels of risk taking activity by financial institutions, but hedging is likely to be more successful in the short term than the long term where changes cannot be predicted with any degree of accuracy. While banks seek to benefit from interest rate volatility, research suggests that banks may be much better off deriving their income from fees, service charges and other non interest based income sources. Increased regulation of banks after financial crises in the past have also resulted in more unregulated lending behavior, which has caused the sub prime crisis and is also affecting bank productivity. Te findings above also suggest that when interest rates are low, risky behavior appears to increment over time. For example, the distribution of home loans to borrowers with poor or no credit was successful at first but this generated too much confidence on the part of lenders, as a result of which further allocations of loans were made with less care applied in lending criteria. This also suggests that bank efficiency and regulation may determine the extent of its success in income generation activity. It is important for banks to maintain strong financial ratios and balance the proportion of their lending so that they maintain adequate liquidity to absorb shocks arising out of interest rate volatility. 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