Low Interest Rates and Risk taking channel of Monetary Policy

From Monetary Policy and Bank Risk Taking

Gianni De Nicolò, Giovanni Dell’Ariccia, Luc Laeven, and Fabian Valencia
July 27, 2010

Part of the blame for the current global financial crisis has fallen, justly or not, on monetary policy. The story goes more or less like this: persistently low real interest rates fueled a boom in asset prices and securitized credit and led financial institutions to take on increasing risk and leverage. Had central banks preempted this buildup of risk by raising interest rates earlier and more aggressively, the consequences of the burst would have been much less severe.1

This claim has become increasingly popular in both academia and the business press, partly because the crisis occurred in the wake of a prolonged period of exceptionally low interest rates and lax liquidity conditions. However, little empirical evidence has been presented to back it up. And theory has had surprisingly little to offer on the subject. Few macroeconomic models have explicitly considered the impact of policy rates on bank risk taking. And models of bank risk taking have yet to incorporate the effects of monetary policy.

From The risk-taking channel of monetary policy in the USA: Evidence from micro-level data

A recent line of research suggests that there is a significant link between a monetary policy of low interest rates over an extended period of time and higher risk-taking by banks. This link points to a different dimension of the monetary transmission mechanism, the so-called risk-taking channel of monetary policy transmission (Borio and Zhu, 2008)

From The risk-taking channel of monetary policy in the USA: Evidence from micro-level data

For many decades commercial banks in the USA operated under a very restrictive regulatory environment. The McFadden Act (1927) restricted commercial banks from intra- and inter-state expansion of their branch network without previous regulatory approval. Furthermore, the Glass- Steagall Act (1933) prohibited, among other things, commercial banks from offering investment services, such as corporate underwriting, securities brokerage, real estate sales or insurance. These Acts meant to increase competition, protect small banks and limit their risk-taking behavior. Eventually, both Acts were repealed by the end of the 1990s; this allowed commercial banks to freely expand their network across counties and states and to join their forces with other financial institutions. Whether the removal of these restrictions on US banking activity has led to a decrease or increase in banks’ risk-taking behavior is an open debate in economic research. Mishkin (1999), for example, argues that the separation of the banking and securities industries restricted the ability of the banks to diversify, and thus to reduce risk. Then again, the demise of the Glass-Steagall Act led to large financial institutions and the well-known moral hazard problem created by a too-big-to- fail policy. This policy seems to have encouraged increased risk taking on the part of large US banks (Boyd and Gertler, 1993).

From The risk-taking channel of monetary policy in the USA: Evidence from micro-level data

Regardless its (questionable) impact on banks’ risk-taking behavior, the fact is that financial deregulation significantly reduced the number of insured US commercial banks from over 14,000 in 1985 to approximately 6,500 in 2010. At the same time, banking industry assets increased significantly from $2.73 trillion in 1985 to $12.1 trillion in 2010. However, this increase was not evenly distributed across the US banking industry and the sector became far more concentrated than during most of its past. For example, the asset share of the largest size group (i.e. organizations with more than $1 billion in assets) rose dramatically from 71% in 1992 to 90% in 2010.

From The risk-taking channel of monetary policy in the USA: Evidence from micro-level data

In this paper, we do not investigate the underlying factors of this consolidation trend. Instead, our focus is primarily on identifying how the gradual restructuring of the US banking industry (in its various manifestations), along with the varying macroeconomic conditions, have influenced the linkage between interest rates and bank risk-taking over time. Hence, adding a temporal dimension to the analysis allows us to better understand the dynamics of the risk-taking channel of the US monetary policy transmission over the last two decades. Throughout this period, the federal funds rate (the primary tool used for implementing monetary policy) varied significantly in accordance with the country’s economic conditions. During the 2000s, the Fed adopted accommodative monetary policies. Following the bursting of the dotcom bubble in late 2000 and the subsequent recession in the US economy, the Federal Open Market Committee (FOMC) began to lower the target for the overnight federal funds rate. Rates fell from 6.5% in late 2000 to 1.75% in December 2001 and to 1% in June 2003. The target rate was left at about 1% for a year. At that time, the historically low federal funds rate resulted in a negative real federal funds rate from November 2002 to August 2005. Remarkably, since the first quarter of 2009 the level of federal funds rate has remained at its all-time low (0.25%). This exceptionally low level is likely to hold for an extended period of time as evidenced by the minutes of the FOMC’s meeting April 27, 2011.

From The risk-taking channel of monetary policy in the USA: Evidence from micro-level data


In forming its central-bank policy rates, the Fed, like other central banks, has the mandate of promoting price stability. However, unlike other banks, the Fed is additionally charged with promoting maximum employment. This dual mandate may well explain the Fed’s recent decision to embark on quantitative easing schemes in an attempt to keep interest rates at low levels in order to promote employment. Although these monetary policy decisions may potentially impair the performance of the banking sector, or change the structure of its risk-taking activities, the Fed avoids taking actions against financial volatility per se, or against banks taking losses or failing. Such actions are believed to raise moral hazard problems, which could ultimately increase, rather than reduce, the risks to the financial system (Plosser, 2007). Thus, the current (and expected) accommodative monetary policy implies that the Fed is more concerned with liquidity injections that facilitate the orderly functioning of the financial markets, rather than protecting banks from the consequences of their financial choices.

Key Research/Analysis Sources:

A) Monetary policy, interest rates and risk-taking

Mikael apel and Carl andreas Claussen; 2012


Click to access rap_pov_artikel_4_120607_eng.pdf


B) Monetary Policy and Bank Risk-Taking: Evidence from the Corporate Loan Market

Teodora Paligorova∗ Bank of Canada

Jo ̃ao A. C. Santos∗

November 22, 2012


http://www.frbsf.org/economic-research/events/2013/january/federal-reserve-day-ahead-financial-markets institutions/files/Session_3_Paper_2_Paligorova_Santos_risk_taking.pdf


C) Monetary policy and the risk-taking channel 

Leonardo Gambacorta
Bank for International Settlements (BIS)

BIS Quarterly Review December 2009

Click to access r_qt0912f.pdf


D) Capital Flows and the Risk-Taking Channel of Monetary Policy

Valentina Bruno Hyun Song Shin

December 19, 2012




E) Bank Risk-Taking, Securitization, Supervision, and Low Interest Rates: Evidence from Lending Standards

Angela Maddaloni and José-Luis Peydró

September 2009

Click to access Shangai_Jan2010.pdf


F) Capital regulation, Risk-Taking and Monetary Policy: A Missing Link in the Transmission Mechanism ?

24-25 September 2009

Claudio Borio

Haibin Zhu



G) Monetary Policy and Bank Risk Taking

Prepared by Gianni De Nicolò, Giovanni Dell’Ariccia, Luc Laeven, and Fabian Valencia* Authorized for Distribution by Olivier Blanchard
July 27, 2010



H) Conducting Monetary Policy at Very Low Short-Term Interest Rates


MAy 2004



I) Does Monetary Policy Affect Bank Risk?

Yener Altunbasa, Leonardo Gambacortab, and David Marques-Ibanezc

March 2014

Click to access 05anares.pdf


J) Interest rates and bank risk-taking

Manthos D Delis and Georgios Kouretas

January 2010

Click to access Interest_rates_and_bank_risk-taking.pdf


K) Monetary Policy, Leverage, and Bank Risk-Taking

Giovanni Dell’Ariccia Luc Laeven Robert Marquez

December 2010

Click to access wp10276.pdf


L) The risk-taking channel of monetary policy in the USA: Evidence from micro-level data

Manthos D Delis and Iftekhar Hasan and Nikolaos Mylonidis

October 2011

Click to access MPRA_paper_34084.pdf



M) Bank Leverage and Monetary Policy’s Risk-Taking Channel: Evidence from the United States



N) Money, Liquidity, and Monetary Policy

Tobias Adrian Hyun Song Shin

January 2009


O) In search for yield?
Survey-based evidence on bank risk taking

Claudia M. Buch

Sandra Eickmeier

Esteban Prieto






by Yener Altunbas, Leonardo Gambacorta and David Marqués-Ibáñez




Q) Monetary policy and the risk-Taking channel: Insights from the lending behaviour of banks

Teodora Paligorova and Jesus A. Sierra Jimenez




Author: Mayank Chaturvedi

You can contact me using this email mchatur at the rate of AOL.COM. My professional profile is on Linkedin.com.

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