Exploring the Relationship Between Interest Rate Volatility and Banking Sector Profitability Across Markets

Posted: Nov 27, 2023

• Aiden Torres
• Alexander Green
• Alexander Hill

Abstract

This research presents a novel methodological framework for analyzing the complex relationship between interest rate volatility and banking sector profitability across diverse market environments. Traditional approaches in financial economics have typically employed linear regression models with limited consideration for the non-linear dynamics and structural breaks inherent in financial time series. Our study introduces a hybrid methodology combining wavelet coherence analysis with regime-switching models to capture the multi-scale, time-varying nature of this relationship. We examine data from 45 banking sectors across developed, emerging, and frontier markets over a 20-year period encompassing multiple financial cycles. The findings reveal previously undocumented asymmetries in how interest rate volatility impacts profitability, with distinct patterns emerging across different market types and temporal scales. Specifically, we identify threshold effects where moderate volatility enhances profitability through trading opportunities, while extreme volatility erodes net interest margins. The cross-market analysis demonstrates that institutional factors, including regulatory frameworks and market development levels, significantly moderate this relationship. Our approach provides a more nuanced understanding of banking sector resilience and offers practical implications for risk management and monetary policy transmission mechanisms in an increasingly volatile global interest rate environment.