Does Market Interest Rate Impact Bank Profitability and Risk?

Over the past four decades, interest rates in the United States fluctuated con- siderably. The benchmark Federal funds rate, for instance, fell from 11.4% in summer 1984 to 3% in early 1993, increased to 6.5% in 2000, fell back to 1% in 2004, increased again to 5.25% in 2007, and bounced back and forth between 0.00% and 5.25% multiple times. Such interest rate fluctuations impact bank profitability and risk. The Dodd-Frank Act of 2010 also introduced activity restrictions and new capital and liquidity requirements for US banking firms. Using a panel dataset, we examine how US banking firms have maneuvered interest rate fluctuations since 1980. We further study bank profitability and risk behavior in the periods before and after the Dodd-Frank Act. Our findings suggest that in general, bank profitability improves with higher Fed funds rate while bank risk parameters suffer. Results are amplified for large banks.