Procyclical bank risk-taking and the lender of last resort

Mark Mink 31 August 2011

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Since the outbreak of the global financial crisis in 2007, and particularly since the bankruptcy of Lehman brothers in September 2008, central banks in their roles as lenders of last resort have provided large-scale liquidity support not only to individual banks, but also to the banking sector as a whole. As President Trichet of the European Central Bank explained in November 2009:

“The Eurosystem’s open market operations have, in addition to steering short-term interest rates, also sought to ensure that solvent banks have continued access to liquidity. [...] We are now providing – and this is quite exceptional – unlimited refinancing to the banks of the Eurozone for maturities ranging from one week to six months in exchange for eligible collateral. [...] In total, the Eurosystem’s balance sheet rose by about €600 billion since end-June 2007 and today, an increase of about 65%”. (Trichet 2009).

While these extraordinary measures were deemed inevitable in stabilising the banking sector, in Mink (2011) I show that the prospect of receiving liquidity support may distort banks’ risk-taking incentives to a much larger extent than has been acknowledged up to now. In particular, in addition to stimulating excessive maturity transformation, the prospect of receiving liquidity support provides banks with an incentive to increase their leverage, diversify their asset portfolio, lower their lending standards, and to do so in a procyclical manner.

It is already well known that the prospect of receiving liquidity support stimulates banks to increase maturity transformation, i.e. to use more short-term and less long-term debt to finance their long-term assets. The prospect of liquidity support, after all, limits the risk that the sudden withdrawal of short-term funds – as occurs in a bank run – will cause liquidity shortages and threaten the bank’s stability. As a result, the bank will be tempted to increase profits by using more short-term instead of long-term debt to finance its activities, as short-term debt usually bears a lower interest rate (as reflected by the upward sloping term structure). Providing banks with liquidity support thus effectively allows them to use maturity transformation as a means to lower their borrowing costs, without worrying too much about the higher illiquidity risk.

Through reducing banks’ borrowing costs, the prospect of receiving liquidity support also stimulates forms of bank risk-taking other than maturity transformation. First, it provides banks with an incentive to increase their leverage, i.e. to use more debt and less equity to finance their activities. Doing so, however, comes at the risk of a small decline in asset value being sufficient to wipe out banks’ equity buffers and cause them to become insolvent. Under the assumptions of Modigliani and Miller (1958), higher firm leverage does not increase shareholder value, since shareholders can also buy shares of an unlevered firm and lever their portfolio themselves. However, a crucial assumption in the Modigliani-Miller framework is that firms borrow against the same interest rates as their shareholders, which for banks is refuted by their ability to borrow against short-term interest rates without running higher illiquidity risks. Because banks can thereby lever their balance sheets against lower costs than shareholders can when levering their investment portfolios, bank leverage increases shareholder value.

Second, the prospect of receiving liquidity support stimulates banks to diversify their asset portfolios. Doing so, however, comes at the risk of asset portfolios becoming near-perfectly correlated with the market portfolio, and therefore with each other as well. The probability of individual bank defaults is then lower, at the cost of a higher probability of joint bank defaults. The incentive to diversify arises from the fact that by increasing its leverage, the bank also increases its default probability, which at some point will reach the limit of what the bank considers to be acceptable. The only way for the bank to further increase leverage from this point is then to first diversify its asset portfolio. Diversification, after all, reduces the variance of the asset returns, so that the probability of default also declines. Bank diversification thus increases shareholder value as it creates room for further bank leverage.

Third, the prospect of receiving liquidity support stimulates banks to lower their lending standards by charging artificially-low interest rates on originated loans. Doing so comes at the risk of a credit bubble, the bursting of which might trigger the outbreak of a financial crisis. The incentive to lower the interest rate on loans arises from the fact that maturity transformation effectively reduces the marginal costs of originating a long-term loan to the short-term interest rate. Competitive pressures will therefore drive the price of a long-term loan to the short-term interest rate as well, causing loans to be issued at prices below the cost-effective level.

The prospect of receiving liquidity support not only stimulates banks to increase maturity transformation, leverage, and diversification, and to lower their lending standards, but also does so in a procyclical manner. The risk-taking stimulus, after all, strengthens when banks’ potential gains from engaging in maturity transformation become larger, which is when the difference between short-term and long-term interest rates becomes larger as well. This difference increases when the term spread steepens, a well-known leading indicator of an upswing in the business cycle. Hence, the prospect of receiving liquidity support stimulates banks to increase risk-taking exactly when the economic outlook is most prosperous.

The above suggests that while bank liquidity support is currently used to combat the instability of the banking sector, the prospect of receiving it might also have been one of the causes of instability. In addition, my analysis underlines the importance of implementing regulatory liquidity requirements to reduce bank maturity transformation, as this will reduce other forms of bank risk-taking as well. Such international liquidity requirements are likely to be implemented via the Basel III banking regulation reform package, in particular via the introduction of the Net Stable Funding Ratio. Banks have opposed the move towards stricter capital and liquidity requirements, arguing that equity and long-term debt are both “expensive” sources of funding. My analysis shows this might only be the case because these funding sources do not allow banks to benefit as much from the illiquidity insurance by the lender of last resort. In that case, as is also argued by Admati et al. 2010), equity and long-term debt would not be an expensive form of funding from the perspective of society as a whole.

Editors' note: The views expressed in this column are those of the author and do not necessarily reflect official positions of the Dutch Central Bank (DNB).

References

Admati, A, P DeMarzo, M Hellwig, and P Pfleiderer (2010), “Fallacies, irrelevant facts, and myths in the discussion of capital regulation: Why bank equity is not expensive”, Working Paper no. 2065, Stanford Graduate School of Business, Stanford, California.
Mink, M (2011), “Procyclical bank risk-taking and the lender of last resort”, Working Paper No. 301, De Nederlandsche Bank, Amsterdam.
Modigliani, F and M Miller (1958), “The cost of capital, corporation finance and the theory of investment”, American Economic Review, 48:261-297.
Trichet, Jean-Claude (2009), “The ECB’s response to the crisis”, Statement by Jean-Claude Trichet, President of the ECB 
at the European American Press Club
 Paris, 20 February.

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Topics:  International finance Macroeconomic policy

Tags:  Central Banks, lender of last resort, financial regulation

Senior Economist, Supervisory Strategy Department, De Nederlandsche Bank

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