Significant link between low-interest policy and bank risk-taking

Despite recent claims by US Federal Reserve chief Ben Bernanke that the Fed's policy of low interest rates was not a contributing cause of the financial crisis, a recent article published by the Bank for International Settlements (BIS) does show evidence of a significant link between the extended period of low interest rates prior to the crisis and increased risk-taking by banks.

Chakravarthi Raghavan

THERE is a significant link between a monetary policy of low interest rates over an extended period of time and increasing risk-taking by banks, according to a special feature article in the December edition of the Bank for International Settlements (BIS)'s Quarterly Review.

The article, 'Monetary policy and the risk-taking channel', comes even as three years into the 'Great Recession' caused by the worst financial crisis since the Great Depression, banks (bailed out by taxpayers) and the financial services industry seem to be returning to business as usual, with 'carry trades' based on near-zero dollar interest rates creating asset bubbles abroad.

Analysing the empirical link between monetary policy and bank risk-taking, the article by Leonardo Gambacorta (which comes with the usual disclaimer that it does not necessarily reflect the views of the BIS) says that there is evidence of a 'significant link' between an extended period of low interest rates prior to the crisis and risk-taking by banks.

The main implication, the article says, is that monetary policy is not fully neutral from a financial stability perspective, and that monetary authorities need to learn how to factor in the effect of their policies on risk-taking. Also, prudential authorities need to be especially vigilant during periods  of  unusually  low  interest rates, 'particularly if they are accompanied by other signs of risk-taking, such as rapid credit and asset price increases'.

Another feature article in the same issue of the BIS Quarterly Review (by Rodrigo Alfaro and Mathias Drehmann) notes that few of the stress tests undertaken before the current crisis uncovered significant vulnerabilities. The structural assumptions underlying stress-testing models do not match output growth around many crises. The vast majority of stress scenarios based on historical data are not severe enough. Also, stress-testing models are not robust, as statistical relationships tend to break down during crises. These insights, Alfaro and Drehmann say, have important implications for the design and conduct of stress tests in the future.

US Federal Reserve policies

The publication of the articles comes at a time when the US Federal Reserve (Fed) and its current chief Ben Bernanke have faced critical questions and even hostile comments in the US Congress over the Fed's policies and the lax regulatory oversight of banks and financial trades that brought on the crisis.

In setting current monetary policy, the Fed on 16 December signalled that the present policy of 'exceptionally low' (near-zero) interest rates would continue for an 'extended period'. The European Central Bank and Japan have also signalled or indicated that their current low-interest monetary policy would continue.

In Congressional testimony (in response to questions and concerns about carry trade and asset bubbles emerging abroad), Bernanke has said that the near-zero interest rates were not fuelling asset price bubbles in the US and that it was not the Fed's job to prevent bubbles abroad. He has been cited in media reports as saying: 'US monetary policy is intended to address both financial and economic issues in the US ... Countries that are concerned about that have their own tools to address bubbles in their own countries.'

This throws the spotlight on the dichotomic policies for financial globalisation being pursued despite the crisis. While the Fed seeks to wash its hands of the consequences of asset bubbles generated abroad through the carry-trade activities of Wall Street firms, the US Trade Representative and the US financial enterprises are at the World Trade Organisation pushing for liberalisation of the 'trade in financial services' and revisiting domestic regulatory disciplines and prudential carve-outs.

Risk-taking channel

The Gambacorta article notes that easy monetary conditions are a classic ingredient of financial crises: low interest rates may contribute to an excessive expansion of credit and, hence, to boom-bust-type business fluctuations. In addition, it says, some recent papers have found a significant link between low interest rates and banks' risk-taking, pointing to a different dimension of the monetary transmission mechanism, the so-called risk-taking channel.

This channel may operate in at least two ways. First, low returns on investments, such as government (risk-free) securities, may increase incentives for banks, asset managers and insurance companies to take on more risk for contractual or institutional reasons (for example, to meet a target nominal  return). Second, low interest rates affect valuations, incomes and cash flows, which in turn can modify how banks measure risk.

Analysing empirically the link between monetary policy and risk-taking by banks in the run-up to the crisis, the article cites studies (based on databases of European and US listed banks) that found evidence that banks' risk of default implied by asset prices shot up by a larger amount in countries where interest rates had remained low for an extended period prior to the crisis. This result is consistent with the existence of a risk-taking channel and holds even if one allows for the influence of a wide range of macroeconomic and microeconomic factors, the article says.

Theoretical basis

In setting the theoretical basis, the article notes that there are a number of ways in which low interest rates can influence risk-taking. The first is through the search for yield, with low interest rates increasing incentives for asset managers to take on more risks for contractual, behavioural or institutional reasons.

This may reflect a number of factors. Some are psychological, such as money illusion: investors may ignore the fact that nominal interest rates may decline to compensate for lower inflation. Others may reflect institutional or regulatory constraints. For example, life insurance companies and pension funds typically manage their assets with reference to their liabilities - linked (statutorily or contractually) in some countries to a minimum guaranteed nominal rate of return or returns reflecting long-term actuarial assumptions rather than the current level of yields.

More generally, financial institutions regularly enter into long-term contracts committing them to produce relatively high nominal rates of return. The same mechanism could be in place whenever private investors use short-term returns as a way of judging manager competence and withdraw funds after poor performance.

The second way that low interest rates can make banks take on more risk is through their impact on valuations, incomes and cash flows. A reduction in the policy rate boosts asset and collateral values, which in turn can modify bank estimates of probabilities of default, loss-given-default and volatilities. For example, low interest rates and increasing asset prices tend to reduce asset price volatility and thus risk perception. This example can be applied to the widespread use of value-at-risk methodologies for economic and regulatory capital purposes.

Citing some stylised facts and empirical evidence, the article notes that in the aftermath of the bursting of the dotcom bubble, many central banks lowered interest rates to combat recession. With inflation remaining remarkably stable, central banks in a number of developed countries kept interest rates below previous historical norms for some time.

The implication of these strategies for risk-taking did not loom large in policy decisions. Most central banks around the world had progressively shifted to tight inflation objectives. Financial innovation, for the most part, had been regarded as a factor that would strengthen the resilience of the financial system, by resulting in a more efficient allocation of risk.

[Paul Volcker, the legendary former Fed chief who advocated the breakup of big financial institutions and called for some form of Glass-Steagall reforms (to separate banking from trading) early in 2009, had caustically remarked that the only financial innovation of benefit to consumers was the ATM machine. Economist Simon Johnson, writing on the New York Times website, has said that 'most of financial innovation, in [Volcker's] view, is not just worthless to society - it is downright dangerous to our broader economic health.']

Empirical evidence

The Gambacorta article cites a study which used micro-data of the Spanish Credit Register over the period 1984-2006. That study found that overall, low interest rates reduce credit risk in banks' portfolios in the short term - since the volume of outstanding loans is larger than the volume of new loans - but raise it in the medium term.

Another study, using data from Bolivia, investigated the impact of changes in interest rates on loan pricing over the period 1999-2003. It found that, when interest rates are low, banks not only increase the number of new risky loans but also reduce the rates they charge risky borrowers relative to those they charge less risky ones. And interestingly, the reduction in the corresponding spread (and the extra risk) is higher for banks with lower capital ratios and more bad loans.

Gambacorta cites another study which took a more international perspective and analysed the link between monetary policy and bank expected default frequencies (EDFs) by using data for 600 European and US listed banks over the period 1999-2008. It found evidence of a link between low interest rates for protracted periods and increased risk-taking by banks over the last decade. This result holds when controlling for a wide set of factors: changes in business cycle expectations, differences in the intensity of bank supervision and changes in bank competition.

The Gambacorta article notes that the recent crisis is a reminder that risks can materialise in non-linear ways. The evolution of banks' EDFs over the last decade shows that the consequences of banks' risk-taking started to emerge suddenly in the third quarter of 2007, triggered by the subprime crisis, and became even more apparent after the Lehman Brothers bankruptcy in September 2008.

There is some preliminary descriptive empirical evidence that low interest rates for an extended period prior to the crisis could have led banks to take on more risks. In the United States, where the federal funds rate was below the benchmarks for an extended period, the subsequent increase in banks' EDFs was greater than in European Union countries, where the policy rate was below the benchmark for only 10 quarters on average.

On the basis of a more formal econometric analysis, the article finds that when interest rates are low for an extended period, banks' EDFs tend to increase.

Interesting findings

The empirical exercise also points to a number of other interesting findings.

First, developments in housing prices prior to the crisis appear to have contributed to bank risk-taking. There is basis for the view that the housing market had a substantial role in the crisis and that banking distress was typically more severe in countries that experienced a more pronounced boom-bust cycle in house prices.

Second, banks that experienced a higher growth rate of lending with respect to the industry average prior to the crisis proved to be riskier ex post.

Third, securitisation appears to play a secondary role in explaining the evolution of bank risk. Banks heavily involved in the securitisation market may not have enough incentives to screen borrowers and monitor loans, which could result in underestimation of risk. Banks that securitised a higher proportion of their assets before the crisis did become riskier during the crisis, but the effect is statistically weak.

The article concludes that the current credit crisis has drawn the attention of researchers and policymakers to the link between monetary policy and risk perceptions and attitudes. There is evidence of a significant link between an extended period of low interest rates prior to the crisis and banks' risk-taking.

The main implication of these findings is that monetary policy is not fully neutral from a financial stability perspective. This is of interest to both monetary and supervisory authorities. It is important that monetary authorities learn how to factor in the effect of their policies on risk-taking, and that prudential authorities be especially vigilant during periods of unusually low interest rates, particularly if they are accompanied by other signs of risk-taking, such as rapid credit and asset price increases.   

Chakravarthi Raghavan is Editor Emeritus of the South-North Development Monitor (SUNS), from which the above article is reproduced (SUNS No. 6839, 21 December 2009). SUNS is published by the Third World Network.

*Third World Resurgence No. 233, January 2010, pp 6-8