The Global Crisis reignited the debate over the link between short-term interest rates and bank risk taking, also known as monetary policy’s ‘risk-taking’ channel – the notion that interest rate policy affects the quality and not just the quantity of bank credit. Many hold the view that interest rates were held too low for too long in the run up to the Crisis (Taylor 2009), and that this helped fuel an asset price boom, spurring financial intermediaries to increase leverage and take on excessive risks (Borio and Zhu 2008, Adrian and Shin 2009).
More recently, a related debate has ensued over whether continued exceptionally low interest rates are setting the stage for the next financial crisis (e.g. Rajan 2010). More generally, there is a lively debate about the extent to which monetary policy frameworks should include financial stability considerations (Woodford 2012, Stein 2014).
Theory offers ambiguous predictions on the relationship between the real interest rate and bank risk-taking. Traditional portfolio allocation models predict that an exogenous increase in interest rates will reduce risk taking. A higher interest rate on safe assets leads to a reallocation from riskier securities towards safe assets, thus reducing the riskiness of the overall portfolio. At the same time, an increase in the risk-free rate may also affect the composition of the pool of risky securities. In particular, assuming that investment projects have limited scalability, a higher risk-free rate raises the hurdle rate for investment and induces agents to cut projects that have low return or/and high risk. The impact on the riskiness of the investment pool is ambiguous (Chodorow-Reich 2014).
In contrast, the risk-shifting channel of monetary policy predicts a positive relationship between interest rates and bank risk taking. In these models, the asymmetric information between banks and their borrowers prevents bank creditors (and depositors) from pricing risk at the margin. This friction together with limited liability leads banks to take excessive risk. As a result, an increase in the interest rate banks have to pay on deposits will exacerbate the agency problem associated with limited liability and inefficiently increase bank risk taking. Further, the strength of this risk-shifting effect depends on the leverage/capital of banks; it is strongest for the least capitalised banks. These banks are more exposed to agency problems, which become more severe when interest rates are higher and their intermediation margins are compressed (e.g. Stiglitz and Weiss 1981). Thus, in traditional risk-shifting models, the least capitalised banks will be the most sensitive to interest rate changes. However, since the relationship between the interest rate and this source of risk taking is opposite to that of the portfolio allocation effect, in models that take both into account, they partly offset each other (Dell’Ariccia et al. 2014).
Specifically, Dell’Ariccia et al. (2014) find that the way changes in risk-free rates affect bank risk taking depends on how much banks are able to pass these changes onto lending rates and on how they optimally adjust their capital structure in response to such changes. The pass-through effect acts through the asset side of a bank’s balance sheet. A reduction in the reference real interest rates is reflected in a reduction of the interest rate on bank loans. This, in turn, reduces the bank’s gross return conditional on its portfolio repaying, reducing the incentive for the bank to monitor. Since the strength of the risk-shifting effect is a function of leverage, the impact of monetary policy on risk taking will be mediated by the degree of bank capitalisation. And since the two effects tend to offset each other, it will be the risk-taking of better capitalised banks that will be more sensitive to changes in interest rates.
Along the same principle as the risk-shifting channel, but going in the opposite direction, there could be a ‘search for yield’ effect for financial intermediaries with long-term liabilities and shorter-term assets (i.e. negative maturity mismatches), such as life insurance companies and pension funds (Rajan 2005). These financial intermediaries may be induced to switch to riskier assets with higher expected yields when monetary easing compresses their margins by lowering the yield on their short-term assets relative to that on their long-term liabilities, and this effect would be more pronounced for less capitalised financial institutions.
The net effect of interest rates on bank risk taking, and its interaction with bank leverage, is therefore an empirical question. A more negative effect for highly capitalised banks would be consistent with the classical risk-shifting effect while a more negative effect for lowly capitalised banks would be consistent with a ‘search for yield’ effect.
In a recent paper, we study the link between short-term interest rates, bank leverage, and bank risk taking using confidential data on individual US banks’ loan ratings from the Federal Reserve’s Survey of Terms of Business Lending (STBL) (Dell’Ariccia et al. 2015).
We find that bank risk taking – as measured by the risk ratings of the bank’s loan portfolio – is negatively associated with short-term interest rates – as proxied by the federal funds rate – and that, consistent with the classical risk-taking channel, this negative relationship is more pronounced for highly-capitalised banks. Our empirical analysis shows that, for the typical new loan, a one standard deviation decrease in interest rates is associated with an increase in loan risk ratings of 0.11 (compared to its standard deviation of 0.8). Moreover, the effect depends on the degree of bank capitalisation – the effect of interest rates on bank risk taking is less pronounced for poorly capitalised banks. The economic effect of this result is meaningful, although its magnitude is not very large – reducing interest rates from their 75th percentile to their 25th percentile would increase loan risk ratings for a strongly capitalised bank (with Tier 1 capital ratio at its 75th percentile) by 0.08 more than for a weakly capitalised bank (with Tier 1 capital ratio at its 25th percentile).
The paper makes two important contributions to the literature on the risk taking channel of monetary policy. First, to our knowledge, the paper is the first to present evidence of a risk-shifting channel of monetary policy for banks by showing that the inverse relationship between interest rates and bank risk taking is increasing in bank capital. This evidence provides a link with the theoretical banking literature on risk shifting, which predicts that risk taking is a function of a bank’s capital. We also find that bank risk taking is related with the component of interest rates that is orthogonal to economic activity, suggesting that our results are not simply reflecting the simultaneous effects of macroeconomic conditions on both bank lending practices and interest rates.
Second, the paper constructs an ex ante measure of bank risk-taking using information on the perceived riskiness of loans to analyse the link between interest rates and bank risk-taking. This allows us to focus on the risk attitude of banks at the time a loan is issued, rather than on ex post loan performance which could be affected by subsequent events. Notably, this restricts our attention to a specific form of risk taking: the extension of new loans. This has two advantages. It greatly reduces concerns about endogeneity of the monetary policy stance. And it focuses on a margin that is fully under the control of a bank (in contrast to the overall riskiness of its portfolio which will largely reflect cyclical changes in the risk profile of existing loans).
Our results contribute to the understanding of the empirical link between monetary policy and bank risk-taking (e.g. Chodorow-Reich 2014, Jimenez et al 2014). Understanding this empirical connection can help inform the design of monetary policy. However, our empirical results and our reduced-form framework cannot determine, by themselves, whether past or present monetary policy is actually optimal.
Authors’ note: The views expressed here are those of the authors and not those of the European Central Bank, Federal Reserve Board, Federal Reserve System, IMF, or IMF Board.
References
Adrian, T and H Song Shin (2009) “Money, liquidity, and monetary policy”, American Economic Review: Papers and Proceedings, 99: 600‒605.
Borio, C and H Zhu (2008) “Capital regulation, risk-taking and monetary policy: A missing link in the transmission mechanism?”, BIS, Working paper No 268.
Chodorow-Reich, G (2014) “Effects of unconventional monetary policy on financial institutions”, Brookings Papers on Economic Activity, (Spring): 155–204.
Dell’Ariccia, G, L Laeven and R Marquez (2014) “Monetary policy, leverage, and bank risk-taking”, Journal of Economic Theory, 149: 65‒99.
Dell’Ariccia, G, L Laeven and G Suarez (2015) “Bank leverage and monetary policy's risk-taking channel: Evidence from the United States”, Journal of Finance, forthcoming. Also available as CEPR Discussion Paper 11230.
Jimenez, G, S Ongena, J L Peydro and J Saurina (2014) “Hazardous times for monetary policy: What do 23 million loans say about the impact of monetary policy on credit risk-taking?” Econometrica, 82: 463–505.
Rajan, R (2005) “Has financial development made the world riskier?”, Proceedings of the Economic Policy Forum of the Federal Reserve Bank of Kansas City, August: 313–369.
Rajan, R (2010) “Why we should exit ultra-low rates: A guest post”, The New York Times: Freakonomics, August 25.
Stein, J (2014) “Incorporating financial stability considerations into a monetary policy framework”, Speech at the International Research Forum on Monetary Policy, Washington, D.C., 21 March.
Stiglitz, J and A Weiss (1981) “Credit rationing in markets with imperfect information”, American Economic Review, 71: 393‒410.
Taylor, J (2009) Getting off track: How government actions and interventions caused, prolonged, and worsened the financial crisis, Hoover Press: Palo Alto.
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