Monetary Tightening's Stress Test: How Interest Rates Reshape Bank Resilience

The International Monetary Fund’s Monetary and Capital Markets Department has released a striking new working paper, authored by Romain Bouis, Sumaiyah Mirza, and Erlend Nier, that explores how rising interest rates are reshaping banks and how macroprudential policies can soften the shocks. Using a massive dataset of more than 2,100 banks across 31 countries between 1995 and 2023, the research dissects three pillars of profitability, loan loss provisions, net interest margins, and non-interest income. The result is a layered picture that shows how the same monetary tightening can strengthen some institutions while destabilizing others, depending on their lending models, funding structures, and the policy environment in which they operate.

When Higher Rates Mean Higher Loan Losses

One of the clearest patterns uncovered is the link between interest rates and loan loss provisions. Banks that extend large shares of flexible-rate loans face immediate pressure as borrowers’ repayment burdens rise when rates increase. This effect is magnified for smaller lenders and for those that expanded aggressively during credit booms, often by taking on riskier customers. In contrast, banks with more conservative loan books weather the storm with fewer defaults. But the most powerful moderating influence comes from macroprudential borrower-based measures, limits on loan-to-value or debt-to-income ratios, that many countries put in place after the global financial crisis. Where such rules had been tight in previous years, the spike in defaults when rates rose was far less severe. These findings suggest that forward-looking prudential policy pays dividends when monetary tightening arrives, shielding banks from a surge in bad loans.

Margins Widen, but Not for Everyone

The second channel of profitability, net interest margins, generally widens as interest rates climb. Banks earn more on loans while deposit costs adjust more slowly, producing a short-term windfall. Yet the paper stresses that this benefit is uneven. Institutions that rely heavily on stable, sticky retail deposits enjoy wider margins, while those dependent on wholesale markets see the advantage eroded almost immediately as market borrowing rates rise. For banks saddled with high levels of non-performing loans, the margin boost can be fleeting: credit quality deteriorates and eats into the gains. The study notes that in countries where most mortgages are at flexible rates, margins widened sharply in the latest hiking cycle, but the same effect was not seen in economies dominated by fixed-rate lending. These nuances demonstrate that net interest margin is no universal stabilizer; it is deeply dependent on funding models and loan structures.

Market Losses and the Squeeze on Non-Interest Income

The third component of bank profitability tells a different story. Non-interest income falls as interest rates rise, mainly because the value of securities on banks’ balance sheets declines. The effect is most pronounced for institutions with large portfolios of assets marked to market, such as trading books. The paper recalls the events of March 2023, when several mid-sized U.S. banks were forced to sell bond portfolios at steep losses, sparking depositor panic and bank runs. By contrast, banks holding more liquid assets fared better, since they could borrow from central banks using those securities as collateral rather than selling them. The study emphasizes that accounting conventions matter: losses are recognized immediately for trading portfolios, but only when realized for held-to-maturity assets. This helps explain why some banks appeared far more resilient than others, even when exposed to the same rate environment.

Policy Lessons: The Power of Prudence

When all three channels are combined, the average effect of higher interest rates on profitability is positive, but the variation across banks is striking. Return on assets rises overall, yet banks with weak balance sheets, risk-heavy portfolios, or a predominance of floating-rate lending can actually see their profitability shrink. For regulators, this is a crucial reminder that high interest rates expose fault lines rather than creating equal outcomes. The most important lesson, according to the authors, is the effectiveness of macroprudential policy. Their newly constructed index of borrower-based measure restrictiveness shows that countries with tighter frameworks enjoy greater resilience, as banks in those systems suffer fewer defaults and smaller hits to profitability during monetary tightening. In other words, prudence during good times pays off when conditions deteriorate.

The broader implication is that monetary and macroprudential policies cannot be viewed in isolation. Central banks raise rates to contain inflation, but whether banking systems absorb or amplify the shock depends on prior regulatory choices. Borrower-based measures act as stabilizers, ensuring that when monetary tightening arrives, households are less overextended and banks face fewer defaults. For central bankers, this means that interest-rate hikes do not inevitably trigger financial instability if macroprudential policy has been robust. For financial regulators, it is a call to action: implementing stricter lending standards in calm times is essential preparation for turbulent ones.

Ultimately, the IMF study reinforces that higher interest rates are neither universally good nor universally bad for banks. Instead, they act as a stress test that reveals the strengths and weaknesses of each institution’s business model and policy environment. Those with stable deposit bases, conservative loan books, and resilient regulatory frameworks can emerge stronger, while others may falter. The evidence from nearly three decades and multiple economies suggests that macroprudential discipline is the decisive factor in determining who wins and who loses when rates rise.