Banks are compensated primarily through the net interest margin (NIM), which is the difference between the interest earned on their investments and the interest paid to their depositors and other creditors. In the low interest rate environment that has persisted since the Great Recession, banks can no longer lower the short-term rates paid to their depositors to below the market rate, so to obtain a higher NIM they must search for higher current yields on assets by taking on more credit risk or non-credit risks (such as interest rate risk). For any given gain in current yield, some types of potential future losses associated with non-credit risks, such as mark-to-market losses due to yield increases, can be avoided with accounting treatments. A simple model shows that a bank's incentive to take on risks for which potential future losses can be managed is countercyclical, especially if a bank is capital constrained or used to have a wider NIM in the past. The loan losses suffered by many banks due to the financial crisis, coupled with the low interest rate environment during the slow recovery, renders it particularly attractive for banks to reach for yield by taking on non-credit risks. This study thus focuses on banks' exposure to interest rate risk through a maturity mismatch between assets and liabilities since the Great Recession. In the United States, a key feature of the post-crisis period has been the wide-ranging regulatory and supervisory reforms enacted to make the nation's banking system safer. Those banking institutions deemed to pose a systemic risk, which are generally the largest (with total assets of $250 billion or more) are now subject to more stringent and extra regulatory requirements, such as the advanced approaches capital rule. In particular, the removal of the so-called accumulated-other-comprehensive-income (AOCI) filter, which used to prevent unrealized gains/losses on the fair value of available-for-sale (AFS) securities from changing the amount of regulatory capital, likely has had the most pronounced disparate impact on incentives to take on more interest rate risk in order to earn a higher NIM. Since this filter was removed only for banks subject to the advanced approaches capital rule, smaller banks presumably have had greater latitude to reach for yield through greater exposure to interest rate risk over the post-crisis years. This study uses Call Report data and difference-in-differences analysis to examine whether, in the post-crisis environment, banks have reached for yield by taking on more interest rate risk, subject to the size-dependent enhancement of regulatory restraints after the crisis. The analysis thus places bank holding companies (BHCs) into one of four groups, depending on the post-crisis regulatory treatment: 1) the largest BHCs (those subject to the advanced approaches capital rule), mostly those with more than $250 billion in assets, 2) those BHCs with assets between $50 and $250 billion, 3) those BHCs with assets above $10 billion but less than $50 billion, and 4) those BHCs with assets under $10 billion. The sample period runs from 1997:Q2 through 2015:Q4; 2007:Q2 marks the start of the financial crisis.
