Monetary Policy and Bank Risk Taking

IMF staff economists look at the relationship between monetary policy and bank risk taking in this paper. Do low central bank interest rates lead banks to take on more risks?

The authors explain there are 3 channels via which low-interest rates can lead to high risk taking:

The arguments in support of this thesis can be broadly grouped under three headings: asset substitution, search for yield, and procyclical leverage.

The asset substitution argument goes as follows. Under relatively general conditions, a lower real yield on safe assets will lead to a decrease in their weight in bank portfolios. Risk-neutral banks will increase their demand for risky assets—hence, in aggregate, reducingtheir yield—until in equilibrium returns on both types of investments are again equalized. Risk-averse agents will generally reallocate their portfolios in a similar fashion under most utility functions (however, agents with decreasing absolute risk aversion will instead decrease their holdings of risky assets).

A related mechanism operates through a “search for yield.” Financial institutions with long-term commitments (such as pension funds and insurance companies) need to match the yield they promised on their liabilities with what they obtain on their assets (Rajan, 2005). When interest rates are high, they can generate the necessary revenue by investing in safe assets. When they are low, they are forced to invest in riskier assets to continue to match the yield on their liabilities (assuming a positive pass-through between the policy rate and the yield on longer-term safe assets).

A complementary view is the leverage channel advanced by Adrian and Shin (2009). They assume that financial institutions target constant (in the case of commercial banks) or procyclical (in the case of investment banks) leverage ratios. When faced with shocks to their portfolios or profits, banks react by buying or selling assets rather than by distributing dividends or raising new capital.

 Further they add that with limited liability and information asymmetry, banks might end up taking even more risk. The findings:

The view that monetary policy easing induces greater risk taking by banks through a search for yield or its effects on leverage and asset prices has become increasingly popular. This paper broadly supports this view. But it also shows that the relationship between real interest rates and bank risk taking is more complex. The reason is that, at least in the short term, two opposite forces are at work. Portfolio reallocation and search for yield effects protected by limited liability points in the opposite direction. The balance depends on the degree to which banks have skin in the game.

Preliminary empirical evidence is consistent with these predictions. Monetary policy easing will increase risk taking, but less so for poorly capitalized banks. These results imply that the impact of monetary policy on bank risk taking is likely to differ across countries and time and be dependent on local banking market conditions (such as bank leverage and charter values and the contestability of banking markets) and factors that affect these conditions (such as business cycles).

 Hmm. What about the interactions between monetary policy and proposed macroprudential policy? 

These findings bear on the debate about how to integrate macroprudential regulation into a macroeconomic policy framework to meet the twin objectives of price and financial stability. Whether price and financial stability are substitutes or complements will depend on the types of shocks the economy is facing and on whether portfolio effects or risk shifting are the dominant force at play.

For instance, there may be no trade-off between price and financial stability when an economy nears the peak of a cycle (when banks tend to take more risk and prices are under pressure). Under these conditions, according to the prevalent view based on portfolio effects and to most empirical evidence, monetary tightening will decrease both risk taking and price pressures. In contrast, a trade-off between the two objectives would emerge in an environment with low inflation but “excessive” risk taking (as may happen when asset price or housing bubbles develop). Under these conditions, the policy rate cannot deal with both objectives at the same time: tightening may reduce risk taking, but will lead to an undesired contraction in aggregate activity (and/or to deflation). The opposite trade-off may manifest itself in the wake of a currency crisis, when inflation is on the rise due to a depreciation of the exchange rate and bank capital is depleted. Then, fighting inflation pressure may come at the cost of increased risk taking.

This is even more interesting and complicated. The linkages between monetary policy, business cycles and financial regulation makes it all so complex. Though there is some clarity on when to use macroprudential policy.

When a trade-off between price and financial stability emerges, macroprudential measures can complement monetary policy and fine-tune its stance by acting in a discriminatory fashion on selected sectors of the economy (IMF, 2010)….

Regulatory policy may be more effective in limiting bank risk taking, either by taxing or restricting financial activities….. For example, capital requirements can be raised to reduce leverage, and lending criteria can be tightened to reduce the risk of banks’ loan portfolios (e.g., limits on loan-to-value ratios can help curb a house price boom).

The next question is should central bank be managing both price and financial stability? The authors say evidence points in centralisation of both the tasks: 

If one accepts the notion that the combination of monetary policy and regulation provides an effective set of tools to deal simultaneously with price stability and financial stability, the question of how to make such policy operational remains. Specifically, this raises the issue of how to coordinate monetary and regulatory authorities. Should these be separate entities or should one agency have responsibility for both stability concerns? The potential interaction among banking market conditions, monetary policy decisions, and bank risk taking implied by our analysis can be seen as an argument in favor of the centralization of macroprudential responsibilities within the monetary authority. And the complexity of this interaction points in the same direction. 

IMF Staff Notes have always been very useful and this one is another useful piece.

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