Scandinavian Working Papers in Economics

Working Papers,
Copenhagen Business School, Department of Economics

No 2-2021: Interest Rate Uncertainty and the Predictability of Bank Revenues

Oguzhan Cepni (), Riza Demirer (), Rangan Gupta () and Ahmet Sensoy ()
Additional contact information
Oguzhan Cepni: Department of Economics, Copenhagen Business School, Postal: Copenhagen Business School, Department of Economics, Porcelaenshaven 16 A. 1. floor, DK-2000 Frederiksberg, Denmark
Riza Demirer: Department of Economics and Finance, Southern Illinois University Edwardsville, Postal: Edwardsville, IL 62026-1102, USA
Rangan Gupta: Department of Economics, University of Pretoria, Postal: Pretoria, 0002, South Africa
Ahmet Sensoy: Bilkent University, Faculty of Business Administration, Postal: Ankara 06800, Turkey

Abstract: This paper examines the predictive power of interest rate uncertainty over pre-provision net revenues (PPNR) in a large panel of bank holding companies (BHC). Utilizing a linear dynamic panel model based on Bayes predictor, we show that supplementing forecasting models with interest rate uncertainty improves the forecasting performance with the augmented model yielding lower forecast errors in comparison to a baseline model which includes unemployment rate, federal funds rate, and spread variables. Further separating PPNRs into two components that reflect net interest and non-interest income, we show that the predictive power of interest rate uncertainty is concentrated on the non-interest component of bank revenues. Finally, examining the point predictions under a severely stressed scenario, we show that the model can successfully predict the negative effect on overall bank revenues with a rise in the non-interest component of income during 2009:Q1. Overall, the findings suggest that stress testing exercises that involve bank revenue models can benefit from the inclusion of interest rate uncertainty and the cross-sectional information embedded in the panel of BHCs.

Keywords: Bank stress tests; Empirical Bayes; Interest rate uncertainty; Out-of-sample forecasts

JEL-codes: C11; C14; C23; G21

21 pages, January 5, 2021

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