Monetary policy and excessive bank risk taking

Itai Agur, Maria Demertzis, 13 January 2011

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Disclaimer: The views expressed in this article are those of the authors only, and do not reflect the views of De Nederlandsche Bank or of its Board.

The financial crisis has reignited the debate on whether monetary policy should target financial stability. Those who favour a policy of leaning against the build-up of financial imbalances (Borio and White 2004, Borio and Zhu 2008, Adrian and Shin 2008, 2009) find themselves strengthened by a growing body of empirical research which shows that the policy rate significantly affects bank risk taking (cited in Agur and Demertzis 2011).

On the other hand, the opponents contend that, even if this is so, it is not clear that it justifies an altered mandate for the monetary authority. Why can’t the bank regulator take care of bank risk? Is there really a need to devote the blunt tool of monetary policy for several targets? (Svensson 2009).

To analyse this question we require a careful modelling of the transmission from monetary policy to bank risk, and its interaction with regulation – something we present in this column.

Transmission channels

In recent research (Agur and Demertzis 2011), we model banks that both choose how much leverage to take on and what type of assets to invest in. Monetary policy is shown to affect bank risk taking through three types of channels.

  • The first is a substitution effect. When the policy rate rises, the instruments with which banks lever up – mostly short-term wholesale funding in the pre-crisis years – become more expensive, so that banks want to lever less. Moreover, bank incentives to lever and to take on asset risk are complementary. The more levered a bank, the greater its limited liability and the less it has to lose from risky loans. Thus, through this channel raising rates lowers bank risk taking.
  • However, the second channel goes in the opposite direction. At a given amount of debt, increasing the cost of banks’ funding instruments enlarges their debt burden, raising their incentive to take risk. This means that a rise in the policy rate is most effective at reducing risk taking when banks are not too heavily levered. In policy terms this means that if a monetary authority wants to prevent the build-up of bank risk, the right time to raise interest rates is early on in the leverage cycle.
  • The third channel runs through bank profits. When rates go up, banks become less profitable and hence the least efficient banks will close their doors. But these are also the banks that tend to select the riskiest profiles, because they are most likely to benefit from their limited liability. Hence, through this channel a rate hike further reduces the riskiness of the financial sector.

The interaction with regulation

We integrate this banking model with a static macro model, within which the task of the bank regulator is defined. We show that regulation cannot neutralise the effects that the policy rate has on bank decision taking. The reason is that monetary policy affects both sides of the regulator’s trade-off.

The regulator’s tool is a leverage cap. On the one hand, capping bank leverage brings about a fall in the supply of credit to firms. On the other hand, the quality of bank loans goes up – that is, banks choose to invest in less risky firms. Both of these affect consumer welfare. And thus the regulator faces a trade-off.

The policy rate affects both sides of this trade-off, but through different mechanisms than the leverage cap. Monetary policy shifts the entire possibilities frontier of the regulator. That is why the regulator has no way of neutralising its impact. We show that the more banks are subject to common shocks, the more important is the role for monetary policy in the financial sector.

The timing of policy

Interestingly, empirics tells us that bank risk not only responds to a rate cut, but that it also matters how long rates are kept low (Maddaloni and Peydro forthcoming, Altunbas et al. 2010). This relates to the argument that in the years leading up to the crisis rates were kept low for too long. Our model can provide some reasoning for why this can be damaging. We make the model dynamic and add a crucial feature, maturity mismatch.

In contrast to their short-term liabilities, banks’ assets are long-term. Because of this, banks will only adjust their portfolios if they foresee that a change to their environment is of long duration. A short-rate cut will not push them to take more risk. But a long lasting cut will. A monetary authority that considers financial imbalances therefore has a different timing of policy than an authority that cares only about inflation and output gap stabilisation.

Yes, we should

Opponents of altering monetary policy strategy tend to believe that nothing should be allowed to compromise the one fundamental target of monetary policy – that is, price stability (Stark 2009). But why do we actually care about price stability? The reason is that deep down we all know that monetary policy is not neutral in the long run. A permanent 20% money growth rate would lead to a lastingly lower rate of GDP growth than a 2% money growth rate, as price instability hampers the functioning of the economy. We would argue that financial stability is analogous. By affecting incentives and long-term loan allocations, monetary policy is not neutral. And that financial instability, like price instability, can seriously impair the functioning of the economy needs no further explanation.

Central banks were originally created in order to promote financial stability (Goodhart 1988). The time has come for them to return to this task.

References

Adrian, Tobias and Hyun Song Shin (2008), "Financial Intermediaries, Financial Stability, and Monetary Policy". Federal Reserve Bank of New York Staff Report No.346.

Adrian, Tobias and Hyun Song Shin (2009), "Financial Intermediaries and Monetary Economics", New York Fed Staff Report No. 398, forthcoming in the Handbook of Monetary Economics.

Agur, Itai and Maria Demertzis (2011), “Excessive Bank Risk Taking and Monetary Policy”, DNB Working Paper 271.

Altunbas, Yener, Leonardo Gambacorta and David Marquez-Ibanez (2010), "Bank Risk and Monetary Policy", Journal of Financial Stability, 6(3):121-129.

Borio, Claudio and William White (2004), "Whither Monetary Policy and Financial Stability? The Implications of Evolving Policy Regimes", BIS Working Paper No.147.

Borio, Claudio and Haibin Zhu (2008), "Capital Regulation, Risk-Taking and Monetary Policy: A Missing Link in the Transmission Mechanism", BIS Working Paper 268.

Goodhart, Charles (1988), The Evolution of Central Banks, MIT Press.

Maddaloni, Angela and José-Luis Peydro (forthcoming), "Does Monetary Policy Affect Credit Standards?", Review of Financial Studies.

Stark, Jürgen (2009), “Monetary Policy Before, During and After the Financial Crisis”, speech at the University of Tübingen, 9 November.

Svensson, Lars (2009), “Flexible Inflation Targeting: Lessons from the Financial Crisis”, speech delivered at De Nederlandsche Bank, 21 September.

Topics: Monetary policy
Tags: financial stability, Leaning against the wind

Itai Agur
Economist, Research Department, De Nederlandsche Bank
Maria Demertzis
DG Ecfin, European Commission