How Central Bank Policy Decisions Affect Banks’ Profitability: A Critical Evaluation

Introduction of Central Banks

Critically Evaluate How the Central Bank Policy Decisions Affect Banks in Profitability.

Central banks are those banks which control the total banking system of any country. Only central banks have the authority of issuing banknotes. The major function of a central bank is to control money supply in the country by handling the interest rates. Central banks act as ‘The lender of the last resort’ to the banks in this sector when there is financial crisis in the economy and banks are unable to cope with the situation. The central banks are the bankers to the government. Central banks supervise the commercial banks as they have to follow the guidelines mentioned by the bank. The central banks focus on the monetary stability, which brings constancy in the flow of money in the nation’s economy. Changes in the attitude for the government roles lead the central banks to develop economy as a major basis (Archer, 2009). With this concern, the paper intends to evaluate the way in which central bank policy decisions affect profitability of banks.

One of the major policies of central bank affecting the profitability of other banks is monetary policy. To evaluate the effect of monetary policy, one should have a complete understanding about the bank’s profitability along with the interest rates (Lambert & Ueda, 2014). The central bank directly purchases securities from the open market influencing long-term rates and guiding market players about short-term rates. The open market operations are mostly used by the Federal Reserve System of central bank in America (Board of Governors of The Federal Reserve System, 2017). In the process, buying and selling of securities such as mortgage-backed securities as well as treasury notes take place from the other commercial banks, which are used as the key tool to increase or decrease interest rates. For instance, if Fed buys a bond from any other bank, the amount of securities will reduce but the amount of reserves will increase. When Fed sells the securities, economic growth and inflation get slower as the interest rate rises while purchasing securities, revival in the economic growth occurs as well as unemployment rates lower down along with a fall in interest rates. Considering the profitability of commercial banks, purchasing of securities by Fed will provide maximum profitability to the commercial banks as its reserves will increase. Investment and loans will be increased with the rise in the price of government securities and their interest rates will fall. Additionally, the overall interest rates will decrease and will provide motivation for new investments in the business (Saylor Academy, 2016).

Evaluation of How Central Bank’s Policy Decisions Affect the Profitability of Other Banks

The yield rate and the interest level rates affect the profitability of the banks. In “retail deposits endowment effect”, the bank deposits are normally priced at a markdown value on market rates along with depicting a market dominated by a small number of sellers. As soon as the interest rate falls, the markdown value in the market falls. This will lead to increase in the net interest income by restricting the monetary policy. Thus, the net interest income of banks is affected due to the monetary policy where the slope of the yield curve remains conclave and leads to bank’s profitability. If the market rate rises, there will be a negative effect on quantity affecting the amount of bank deposits as well as loans. For instance, people prefer bank loans when the lending rates are lower along with increasing the net interest income temporarily. Correspondingly, if the lending rates rise in the future, it will hinder the profitability of the banks. The monetary policy also affects the non-interest incomes of the commercial banks. Keeping all other factors constant, if the bank interest rates get higher, the securities portfolio’s of banks will incur losses. When the securities will be available for sale in the present financial situation, the losses will be presented in the income statement and it will be applicable for equity. The impact of these losses can be observed during the realization of securities held at maturity. This effect is a temporary and will disappear as the effect of change of interest rates gets over. Hence, the process is affecting other bank’s profitability during its course (Borio, Gambacorta & Hofmann, 2015). According to Bank of Israel (2014), hedging of interest rate risk is very essential for banks. Hedging is normally done by swapping interest rates to reduce the substantial losses or gains of the banks leading to non-interest income. Other than this, fees and commissions earned are also a part of non- interest incomes which come from deposit and lending activities as well as investment-banking-type activities. The activities may include trading, credit lines, mergers and acquisitions, and transaction services among others. Thus, non-interest incomes lead to losses for the banks & affect their profitability. Lastly, loan loss provisions cover the loss from loans due to customer defaults or bad loans. During a financial crisis, low interest rates are witnessed. The condition of loans loss provisions are sensitively very high at interest rates which are low. The banks cannot bear any further losses. As the interest rate is extremely low, people will be encouraged to take more loans from the banks encouraging loan growth. This will lower down the ratio of loan loss provisions to the amount of loans increasing more amounts of unrecoverable loans from customers leading to loss of banks and affecting their profitability at large (Borio, Gambacorta & Hofmann, 2015).

Conclusion

Apart from the above, the rate at which central banks apply or signal the position of monetary policy, is known as Central Bank Policy Rate (CBPR). This rate varies and is considered as discount rates as well as repurchase agreement rate in different countries (IMF Data, n.d.). The CBPR varies for each policy interest rate based on alterations in discount rates and repurchase agreement. For instance, the different policy rates of the central banks around the world in the last 4 quarters are shown below:

Figure 1: Central Bank Policy Rate

Source: (IMF Data, 2017)

Conclusion

Based on the above discussion, it can be observed that central banks policies are linked to bank’s profitability. These policies directly or indirectly influence banks profitability by different analysis of financial system. According to The Central Bank of The Bahamas (2017), monetary policy is different from fiscal policy. Fiscal policy is the step taken by government not by central banks to influence a nation’s economy while, monetary policy is set by central banks. Fiscal policy is related to tax revenue and expenditure for the government and focuses essentially on economic growth, unlike economic stability by monetary policy. Fiscal policy is changed on a yearly basis while monetary policy is changed depending on the nation’s status in the economy (Borio, Gambacorta & Hofmann, 2015). The increases in the rate of central banks lead to the rise in the commercial bank’s lending rates which discourage to borrow accordingly. This leads to decline in the profitability of the banks as customers will be looking for other sources of financing such as non-banking financial institutions (Mungai, 2013). Thus, for better profitability of the commercial banks, central banks must work upon to design appropriate bank-specific monetary policy that will cover the macroeconomic conditions and will help in funding currencies (Borio, Gambacorta & Hofmann, 2015). The monetary policy is hence made to stabilize the output and control inflation which brings changes in the policy interest rates of the central banks in different nations. Hence, the changes of policy interest rates in central banks, will in turn develop into affecting the probability of all other commercial banks in the world (Mathai, 2012). Therefore, the contribution of central banks is immense for the growth of any bank globally.

References

Archer, D 2009. ‘Roles and objectives of modern central banks’. Issues in the Governance of Central Banks, pp.17-55.

Bank of Israel, 2014, ‘Management of Interest Rate Risk’, Proper Conduct of Banking Business Directive [1] (5/13) Management of Interest Rate Risk, pp.333-1-333-41.

Borio, C, Gambacorta, L & Hofmann, B 2015, ‘Bank for International Settlements’, The Influence Of Monetary Policy On Bank Profitability, no. 514, pp.5-37.

Lambert, F & Ueda, K 2014, The effects of unconventional monetary policies on bank soundness, International Monetary Fund, Washington, D.C.

Mungai, M A, 2013, ‘The role of central bank rate on commercial banks profitability in Kenya’, School of Business, University of Nairobi, pp.1-65.

Saylor Academy, 2016, Chapter 14. The Money Supply Process The Central Bank, viewed 15 May 2017, < https://www.saylor.org/site/wp-content/uploads/2011/07/ECON302-4.2.pdf >.

The Central Bank of The Bahamas, 2017, what is monetary policy and how is it different from fiscal policy? The Central Bank, viewed 21 April 2017, <https://www.centralbankbahamas.com/faqs.php?cat=18&id=10145>.

IMF Data, No Date, What is the Central Bank policy rate? International monetary fund, viewed 22 May 2017, < https://datahelp.imf.org/knowledgebase/articles/484375-what-is-the-central-bank-policy-rate>.

IMF Data, 2017, Interest rates and share prices, Access to macroeconomic & financial data, viewed 22 May 2017, < https://data.imf.org/?sk=5477ad05-460d-4c91-9690-11e99b1ed935&sId=1390030109571>.

Board of Governors of The Federal Reserve System, 2017, Open market operations, Credit and Liquidity Programs and the Balance Sheet, viewed 22 May 2017, < https://www.federalreserve.gov/monetarypolicy/bst_openmarketops.htm>.

Mathai, K 2012, Monetary Policy: Stabilizing Prices and Output, International monetary fund, viewed 22 May 2017, <https://www.imf.org/external/pubs/ft/fandd/basics/monpol.htm>.