THE DETERMINANTS OF BANK INTEREST MARGINS: THEORY AND EMPIRICAL EVIDENCE.

This paper has developed a model of hank margins or spreads in which tile bank is viewed as a risk-averse dealer. It was demonstrated that an interest spread or margin would always exist, and that this was the result of transactions uncertainty faced by the bank. Moreover, it was shown that this pure spread depended on four factors: the degree of managerial risk aversion; the size of transactions undertaken by the bank; bank market structure; and the variance of interest rates. The model implied that liability and asset structures had to he analyzed together since they were directly interrelated through transactions uncertainty. It was shown that because of this transactions uncertainty, hedging behavior was perfectly rational within an expected utility maximizing framework. Extending the model from a structure with one kind of loan and deposit to loans and deposits with many maturities should lead to further interesting insights into margin determination especially as "portfolio" effects may become apparent. In the empirical section, tests were undertaken using data from a sample of U.S. commercial banks. It was shown, given certain reasonable assumptions, that tho pure spread could be empirically identified. It was found that this spread was positively and significantly related to the variance in the tale on Sends as predicted by the theoretical model. It was also inferred that the asset (liability) maturity, or duration, of major concern to this group of banks was one year. When the sample was split into two subgroups (measured by asset size), it was found that the smaller banks had an average transactions spread of approximately one-third of one percent more than the larger banks. While this difference was small, it appeared to be statistically significant. Statistical tests were then conducted to see which factors explained this difference. It was tentatively concluded that the difference was largely due to market structure factors which allowed the... [ABSTRACT FROM AUTHOR]