Heterogeneity in Net-Interest Income Exposure to Interest Rate Risk and Non-Interest Expense Adjustment

In this paper I document two new facts. First, bank net-interest margins (NIM) are insensitive to the short rate on average but this masks substantial heterogeneity in the cross section. I find cross sectional variation ranging from a -30bp to +40bp change in one quarter NIM after a 100bp change in rates, which compounds over the following four quarters. I find that this cross sectional heterogeneity is driven by differences in bank business models: banks with large negative NIM sensitivity to rate changes hold more residential mortgages, and rely more on interest bearing deposits whereas banks with large positive NIM sensitivity hold more typically shorter term commercial and industrial loans and rely more on non-interest bearing deposits. Second, bank NIM sensitivity to rate changes is muted by offsets in non-interest expenses, reducing ROA sensitivity by approximately 30% on average. The positive relationship between net-interest income and non-interest expenses is not consistent with investment sensitivity to cash-flows as a result of costly external funds, but is somewhat consistent with investment sensitivity to profitability. However I also find that banks pass through NIM declines on the upside but not the downside, and the intensity of the relationship between net-interest income and non-interest expenses substantially increases closer to fiscal year end. These adjustments are consistent with the management of expenses in order to prop up earnings to meet executive performance targets, and have the side effect of reducing earnings sensitivity to rate changes.