Optimal bank interest margin and default risk in equity returns under the return to domestic retail with structural breaks

Abstract

A retrenchment in crossborder credit is under way, the product of both market forces and political pressure on international banks to lend at home (Economist, 2009). In addition, banks, particularly the largest, have also dramatically expanded their retail banking operations over the past few years (Hirtle and Stiroh, 2007). Our goal, in this article, is to study the effects of default risk on equity returns through bank interest margin management under a renewed focus on domestic retail banking, a trend often attributed to the stability of banking activities. Specifically, this article explores the determinants of optimal bank interest margins based on an option-based firm-theoretical model with multiple sources of structural breaks due to political pressure. The model demonstrates how capital regulation and political pressure on foreign lending return and risk conditions jointly determine the optimal bank interest margin decision. We show that a more stringent capital requirement is linked with lower equity return, but higher default risk of the bank in the return to domestic retail banking. An increased focus on the political pressure on foreign lending return is linked with higher equity return and default risk of the bank. It is also showed that an increased focus on the political pressure on foreign lending risk decreases the bank's equity return and default risk. We conclude that the return to domestic retail banking may be a relatively stable activity when the political pressure decision impacts only the expected risk of the bank's foreign lending and not the return.

Keywords:

• bank interest margin
• structural break
• retail banking
• political pressure

JEL Classification:

• L21
• D21
• L81
• B41

Notes

¹ Allen (1988) has provided a model of bank interest margin based on the bid–ask spread model of Stoll (1978). Unlike the previous formulation, the model developed by Zarruk and Madura (1992) assumes a setting in which the bank is subject to prevailing capital regulation and deposit insurance. Wong (1997) uses a ‘cost of goods sold’ approach to study the determination of optimal bank interest margins with credit risk and interest rate risk.

² Alternatively, Stulz (2005) presents the limits of financial globalization, including portfolio choice (Ahearne et al., 2004) and stock returns (Brooks and Del Negro, 2002).

³ Currently 92% all of insured financial institutions are charged no deposit insurance premia at all (Chen et al., 2006)

⁴ Chu et al. (2007) also examine bank capitalization and lending behaviour after the introduction of the Basle Accord. However, the loan-rate-setting behaviour is ignored in their arguments.

⁵ For an analysis of the effects of rebalancing the pillars of Basel II on the portfolio of bank assets, see Rochet (2004).

⁶ O’Hara (1990) uses the same assumption to analyse alternative financial contracts for international lending.

⁷ Vassalou and Xing (2004) developed a theoretical probability of default with exactly this structure.

⁸ All that is really needed is that the deposit rate is less than R, so the bank earns rents on its deposit franchise and will be willing to invest in securities to support it (Kashyap et al., 2002).

⁹ For example, George Provopoulos, the governor of Greece's central bank, warned Greek banks not to send funds abroad (Economist, 2009).