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TERM SPREADS AND BANK PROFITABILITY: New evidence of how quantitative easing can influence long-term interest rates and future output

  • Published Date: December 2014

The term spread – an important component of the difference between short- and long-term interest rates – is strongly influenced by banks’ expectations of their future profitability: the higher the expected profits, the lower the spreads. Central banks can thus have an impact on long-term interest rates – and, as a consequence, on future real output – using unconventional monetary policies that protect banks from potential liquidity shortages and relax future balance sheet constraints.

These are among the findings of research by Yunus Aksoy and Henrique Basso, published in the December 2014 issue of the Economic Journal. They note that the slope of the yield curve – which charts the differences in interest rates across the spectrum from short- to long-term – is helpful in predicting future business cycles. This predictive power relates to the future path of short-term interest rates and the variations in term spreads.

Furthermore, recent large-scale purchase programmes adopted by central banks have had a significant impact on the shape of the yield curve, increasing the importance of understanding and modelling the fluctuations in term spreads.

This new study focuses on the role of financial intermediation in the determination of term spreads. The researchers’ framework delivers variations in the slope of the interest rate curve driven by banks’ portfolio decisions while facing the risk of maturity transformation. Future profitability of banks’ portfolios influences their asset allocation, which in turn, determines the term premium they require to carry the maturity risk.

The researchers find that:

· When expected bank profitability is relatively high (low) term spreads are low (high).

· A one percentage point increase in future bank profitability leads to a 13 basis points decrease in term spreads.

· Unconventional monetary policy exploits a new channel of policy transmission through banks’ portfolio choice and alters the yield curve.

In the researchers’ framework, banks hold a portfolio of equities, short- and long-term lending funded by short-term borrowing, thus they bear the risk of maturity transformation. They assume banks may need to make a liquidity injection to their balance sheet to maintain the long-term assets in their books. This formalises the maturity mismatch risk.

Term spreads, which ultimately denote the cost of hedging this potential risk, are determined by the volatility of future short-term rates and the premium for bearing the maturity risk. The researchers show that cashflow patterns affect banks’ profitability and hence their balance sheets, altering the risk premia derived from their portfolio decisions. They label this mechanism the bank’s ‘portfolio channel’.

Their theoretical model generates term premia movements that are good predictors of future real output. As output growth falls during a recession, profitability is expected to remain low and to increase in the future and hence spreads are high; it is costly to pay variable funding costs in the short term to increase long-term earnings. The opposite occurs during a boom.

The researchers analyse the impact of unconventional monetary policies (quantitative easing, QE) recently adopted in major economies, exploring a novel policy channel. The monetary authority, by altering banks’ balance sheet conditions, influences long-term rates and investment without relying on base rate changes.

Unconventional monetary policy aims to protect banks from potential liquidity shortages in the future and relaxes future balance sheet constraints. This in turn leads to an increase in banks’ willingness to carry maturity transformation risk and to a reduction in term spreads. Allowing banks to sell long-term assets to the central bank after a liquidity shock leads to a sharp decrease in term spreads, matching the results presented by several empirical studies of QE policies in major economies.

Empirically, the researchers look at the role of the variability of expected bank profits and the maturity transformation risk. They document bank-level evidence on the link between expected profitability and yield spreads. They find that an increase in US bank-level expected financial business profitability leads to a significant decline in yield spreads next to variations in real output and inflation.

ENDS

Notes for editors: ‘Liquidity, Term Spreads and Monetary Policy’ by Yunus Aksoy and Henrique Basso is published in the December 2014 issue of the Economic Journal.

Yunus Aksoy is at Birkbeck College, University of London. Henrique Basso is at the Bank of Spain.

For further information: contact Romesh Vaitilingam on +44-7768-661095 (email: romesh@vaitilingam.com; Twitter: @econromesh); or Henrique Basso via email: henrique.basso@bde.es