Bank profits' reaction to monetary policy under balance sheet constraints
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2024-06-06
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Pannella, Pierluca
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Do bank profits rise when the interest rate goes up? On one hand, some amount of market power enables banks to obtain higher profits; on the other hand, higher balance sheet constraints mean banks forego profitable investing opportunities, decreasing their profits. We construct a stylized model that captures this effect and show under which conditions profits decrease as the interest rate increases. In the model, an interest rate increase leads households to substitute deposits for other assets and banks become more financially restricted, ensuing lower profits. Empirically, we use a high-frequency monetary policy shock from Miranda-Agrippino and Ricco (2021) and show that bank profits correlate negatively with said shock when banks are undercapitalized, albeit of a very small magnitude. This suggests that, for undercapitalized banks, the balance sheet effect weakly dominates banks’ market power influence.