The risk-return framework of banks’ profitability

This paper investigates how cyclical systemic risk affects the risk-return relationship in bank profitability in Portugal at different horizons, which is key for bank solvency and financial stability.

Macroprudential policy became prominent after the 2008 Global Financial Crisis. This new policy area may tighten bank capital requirements such that banks stay resilient against systemic risk, i.e. any risk that threatens financial stability and could spill over to the economy. Systemic risk is often cyclical, and tightening capital requirements today entails costs and benefits at different horizons.

The paper defines the risk to bank profitability as the contribution of cyclical systemic risk to a measure of uncertainty (downside risk) and the return is defined as the contribution of cyclical systemic risk to expected profitability.

The paper finds that in the first quarter of 2006, before the 2008 global financial crisis, the prevailing levels of cyclical systemic risk and bank capitalization contributed to increasing short-term expected profitability as well as the uncertainty in bank profitability in the medium term. Macroprudential policy can change this relationship between expected bank profitability in the short term and uncertainty in profitability in the medium term by increasing the capital- based resilience of banks.

The paper then simulates the impact of increasing bank capital requirements on the risk-return relationship in bank profitability in the first quarter of 2006. Higher capital requirements imply lower expected profitability in the short term but bring the benefit of reducing the uncertainty in profitability in the medium term.

Click here to go to the paper by Ana Pereira and Joana Passinhas.