Commercial bank net interest margins, default risk, interest-rate risk, and off-balance sheet banking

This paper tests the hypothesis that banks with more risky loans and higher interest-rate risk exposure would select loan and deposit rates to achieve higher net interest margins. Call Report data for different size classes of banks for 1989-1993 show that the net interest margins of commercial banks reflect both default and interest-rate risk premia. The net interest margins of money-center banks are affected by default risk, but not by interest rate risk, which is consistent with their greater concentration in short-term assets and off-balance sheet (OBS) hedging instruments. By contrast, (super-) regional banking firms are sensitive to interest-rate risk but not to default risk. The data show that OBS activities promote a more diversified, margins-generating asset base than deposit- or equity-financing, and that cross-sectional differences in interest-rate risk and liquidity risk are related to differences in OBS exposure.