Dynamic Impact of Market Interest Rates on Bank Interest Income : the Korean Case

We develop an analytical framework for studying the dynamic behavior of bank interest income in response to changes in market interest rates. We use the loan-to-deposit interest rate margin (the ‘margin’) as an indicator for bank profits and incorporate the predominance of floating rate loans, a distinctive feature of the Korean loan markets, in the model. The main findings are summarized as follows. First, that the predominance of floating-rate loans makes the margin correlate positively with market interest rates. Second, that the response of the margin to a change in market interest rates is non-linear; it widens in the short term until the interest rate reset on loans is complete, reaches a peak level around three months later, and then narrows afterward to gradually return to the pre-shock level. Third, that the negative correlation between the margin and market interest rates observed before the 2008 crisis was due largely to the heightened competition or funding pressure caused by the credit boom during that period.