Borrower-based macroprudential measures are meant to provide a guardrail to counter an erosion of lending standards over time. This column explores whether such measures can contribute to more resilient bank profitability by mitigating the effects of higher interest rates on bank loan loss provisions. Higher interest rates are found to lead to larger loan loss provisions, especially for banks offering flexible-rate loans, but this effect is attenuated when borrower-based measures have been tight in preceding years. Tighter macroprudential settings also reduce the effect of higher unemployment on loan loss provisions, and thereby the negative impact of unemployment on bank profitability and stability.

Most of the major banking crises in modern economic history have been preceded by a U-shape in monetary policy rates, where rates are hiked following a prolonged period of low rates (Jimenez et al. 2022). Conceivably, when rates stay low for long, lending standards worsen progressively, sowing the seeds of a crisis when rates ultimately rise (Jiménez et al. 2014). 

Conceptually, while higher interest rates will often strengthen banks’ net interest margins, thereby supporting stability, they can also raise loan defaults and hence the need for banks to provision for loan losses (e.g. Nier and Kang, 2016). This default channel may be at work especially when loans are contracted at flexible rates (Uppal 2025), since higher interest rates then drive up the ratio of the debt service relative to the available income. When higher interest rates also lead to increases in the unemployment rate and a drop in income, the debt service-to-income ratio increases even more, further raising defaults and weighing on profitability. 

Do higher interest rates always lead to more borrower defaults and loan losses? In our recent paper (Bouis et al. 2025), we investigate the role of borrower-based measures (BBMs) in supporting financial stability when interest rates go up. BBMs – such as loan-to-value, debt service-to-income, and loan-to-income caps – are meant to provide a guardrail to counter an erosion of lending standards over time (ESRB 2019). Their use was already common in emerging markets ahead of the global financial crisis, but more countries have introduced such measures since the crisis (Alam et al. 2025).

We build a new index of the restrictiveness of BBMs based on the IMF Macroprudential Policy Survey and the integrated Macroprudential Policy (iMaPP) databases and use it to study empirically the effects of BBMs in a panel of more than 2,000 banks across 31 countries (24 advanced and 7 emerging market economies) over the period 1995 to 2023.

Loan loss provisions rise with interest rates, especially for flexible-rate loans and for banks taking greater risk

When interest rates increase, the higher debt service burden of borrowers with flexible-rate loans should translate into a higher probability of default. In line with this prediction, banks with a high share of flexible-rate lending experience greater increases in loan loss provisions when interest rates rise. Banks with a relatively small market share also see a larger increase in loan loss provisions when interest rates are higher. These banks may have an incentive to take riskier exposures to grow their market share, which then makes them more vulnerable to higher interest rates.

The effect of interest rates on loan loss provisions is, however, mitigated when borrower-based measures have been restrictive in the years preceding high rates

We find that BBMs represent important tools to limit loan losses. For each country, we use the moving average of the reading of the BBM index over the past five years and find that the effect of the interest rate on loan loss provisions for loans at flexible rates is significantly smaller when BBMs have been tight in the preceding five years. So much so, in fact, that the increase in loan losses can be fully neutralised.

For instance, for banks mainly extending loans at flexible rates, and in the absence of BBMs, a one standard deviation increase in the interest rate (+3.5 percentage points) is significantly associated (at the 0.1% confidence level) with an increase in loan loss provisions of almost 0.25 percentage points (first bar of Figure 1). But the same interest rate increase is associated with a statistically non-significant increase in loan loss provisions of 0.07 percentage points in case BBMs have been tight in the previous years (third bar of Figure 1).

Figure 1 Effect of a one standard deviation increase of the interest rate (3.5 percentage points) on bank loan loss provisions – for banks with a high share of flexible-rate loans (percentage points)

Note: Effects reported for banks with flexible-rate loans, with 95% confidence interval error bars.
Source: Bouis et al. (2025).

Macroprudential policies also mitigate the impact of unemployment shocks on loan loss provisions

Unemployment is an important driver of borrowers’ probability of default and banks’ loan loss provisions. By reducing the income that borrowers have available to service their debt, unemployment raises the ratio of debt service to income for both flexible- and fixed-rate loans and can therefore induce broader increases in loan defaults. For our sample of banks, and in the absence of BBMs, a one standard deviation increase of the change of the unemployment rate (+1.0 percentage point) is found to significantly increase (at the 0.1% confidence level) banks’ loan loss provisions of all types of loans by 0.1 percentage points (first bar of Figure 2). However, the same shock in the unemployment rate is associated with a statistically non-significant increase in loan loss provisions of less than 0.01 percentage points (third bar on Figure 2) if BBMs have been tight in the years preceding the shock.

Figure 2 Effects of a one standard deviation increase of the unemployment rate change (1.0 percentage points) on bank loan loss provisions (percentage points)

Note: Effects reported with 95% confidence interval error bars
Source: Bouis et al. (2025).

Net interest margins increase on average, but outcomes vary

Higher interest rates generally boost net interest margins, an effect that could potentially mitigate or even dominate the impact of higher interest rates on loan loss provisions. The benefits of higher interest rates for the net interest margin are, however, uneven. Banks with large deposit bases are found to see stronger positive effects from high interest rates than other banks. The net interest margin of banks with a high proportion of flexible-rate lending and low average levels of nonperforming loans (NPLs) also increases more with a higher interest rate. However, banks with weaker average balance sheets that extend loans at variable rates experience a smaller increase in their interest income as the interest rate increases, possibly reflecting a larger migration of flexible-rate loans into NPLs. 

Overall profitability depends on bank characteristics and is supported by BBMs

In line with existing evidence, bank profitability, as measured by the return on assets (ROA), increases on average with higher interest rates. However, heterogeneity across banks is significant, with risk appetite, sensitivity of loans to interest rates, and funding models all shaping outcomes. Specifically, for risky banks – those that show high average NPLs – which also extend loans at flexible rates, the net effect of higher interest rates on ROA is negative, while it can remain positive for other banks.

Importantly, and in line with the main results for loan loss provisions, borrower-based macroprudential measures are found to mitigate negative effects on profitability of macroeconomic shocks. This holds for the effect on profits of higher interest rates – for banks extending loans at flexible rates – and for the effects on profit of higher unemployment more generally.

Policy implications

Our analysis adds to emerging evidence of the resilience-building effect of macroprudential measures. At the macroeconomic level, a study by the Bank for International Settlements finds that macroprudential measures reduce the risk of financial stress as interest rates increase and thereby provide central banks with more policy headroom to fight inflation (Boissay et al. 2023).

The bank-level results on the effect of BBMs we present here are in line with these findings. They provide even stronger identification of the underlying effects and thereby strengthen the notion that BBMs can render important benefits for financial stability.

In that respect, and while several other forces may also have been at work, BBMs that were introduced and/or tightened in the wake of the global financial crisis may have contributed to greater stability of banks in the more recent tightening episode compared to the tightening cycle that led up to the crisis.

Source : VOXeu