February 2020

Profits, Credit Spreads, and Fragility of Banks

This publication is a part of:

Collection: OCC Working Papers – Banking Performance and Reg

Abstract

We provide evidence that the sensitivity of bank profits to credit spreads captures systematic tail risk exposure of banks associated with sentiment in the US. In the cross section, higher profit sensitivity predicts lower equity returns in systematic tail events. Furthermore, prior to the global financial crisis, banks in the top quartile of profit sensitivity decreased their holdings of short-term securities and US government and agency securities more than banks in the bottom quartile, which particularly helped increase their interest income. These portfolio shifts and associated increases in interest income, however, reversed in the crisis. In the time series, the average profit sensitivity more robustly predicts future economic outcomes than loan growth.

Authors

Ding Du