Working Paper Series
Bank leverage and monetary
policy’s risk-taking channel:
evidence from the United States
Giovanni Dell’Ariccia,
Luc Laeven
and Gustavo A. Suarez
No 1903 / May 2016
Note: This Working Paper should not be reported as representing the views of the European Central Bank (ECB).
The views expressed are those of the authors and do not necessarily reflect those of the ECB
.
ABSTRACT
We present evidence of a risk-taking channel of monetary policy for the U.S. banking
system. We use confidential data on banks’ internal ratings on loans to businesses over the
period 1997 to 2011 from the Federal Reserve’s survey of terms of business lending. We
find that ex-ante risk taking by banks (measured by the risk rating of new loans) is
negatively associated with increases in short-term interest rates. This relationship is more
pronounced in regions that are less in sync with the nationwide business cycle, and less
pronounced for banks with relatively low capital or during periods of financial distress.
JEL classifications: E43, E52, G21
Keywords: Interest rates, monetary policy, banks, leverage, risk
ECB Working Paper 1903, May 2016
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Non-Technical Summary
The global financial crisis has reignited the debate on 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. Some hold the
view that interest rates were held too low for too long in the run up to the crisis, and that this
helped fuel an asset price boom, spurring financial intermediaries to increase leverage and take
on excessive risks.
This paper presents evidence of a risk-taking channel of monetary policy for the U.S.
banking system. We use confidential data on banks’ internal ratings on the quality of loans to
businesses from the Federal Reserve’s survey of terms of business lending. We find that the
quality of lending – measured by the risk rating of new loans – goes down when short-term
interest rates decrease. Consistent with a risk-shifting channel whereby equity owners of the
bank transfer risk onto its debtholders, we find that the effect depends on the degree of bank
capitalization: the effect of interest rates on bank risk taking is less pronounced for poorly
capitalized banks. Moreover, this relationship is more pronounced in regions that fluctuate less
with the nationwide business cycle and less pronounced during periods when banking conditions
are weak.
Taken together, our results indicate that interest rates have a small but economically
meaningful effect on bank risk taking. Importantly our results are not well suited to answer
whether or not the additional risk taking of banks in response to lower interest rates is excessive
from society’s standpoint. Moreover these results focus on a very specific margin of risk taking –
the riskiness of new loans – and the effect on riskiness of the overall asset portfolio of banks
could be different.
ECB Working Paper 1903, May 2016
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I. Introduction
The global financial crisis has reignited the debate on 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.
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Specifically, 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,
2010), and Acharya and Naqvi (2012)).
More recently, a related debate has ensued on whether continued exceptionally low
interest rates (including because of unconventional monetary policy measures) are setting the
stage for the next financial crisis (e.g., Rajan (2010), Krishnamurthy and Vissing-Jorgensen
(2011), Farhi and Tirole (2012), and Chodorow-Reich (2014)). More generally, there is a lively
debate about the extent to which monetary policy frameworks should include financial stability
considerations (Woodford (2012) and 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
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Financial accelerator models, while considering credit risk, have little to say about the implications of changes in
interest rates on bank risk taking. In these models, monetary policy tightening, by increasing risk-free interest rates,
leads to more severe agency problems by depressing borrowers net worth (Bernanke and Gertler (1989); and
Bernanke, Gertler, and Gilchrist (1996)). The resulting equilibrium is one in which firms and banks more affected
by agency problems find it harder to obtain external financing as more credit goes to firms with higher net worth.
These models have little to say about overall credit risk in the system: while agency problems increase across the
board, the marginal firm obtaining financing is of relatively better quality.
ECB Working Paper 1903, May 2016
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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
(Fishburn and Porter (1976)). 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 the strongest for
the least capitalized banks. These banks are more exposed to agency problems, which become
more severe when interest rates are higher and their intermediation margins are compressed (see,
for instance, Stiglitz and Weiss (1981), Hellman, Murdock, and Stiglitz (2000), and Acharya and
Viswanathan (2011)). Thus, in traditional risk-shifting models, the least capitalized 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, Laeven, and Marquez
(2014)).
ECB Working Paper 1903, May 2016
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