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Tilburg University






From the start of the crisis in the summer of 2007 market commentators were quick to argue that, during the long period of very low interest rates from 2002 to 2005, banks had softened their lending standards and taken on excessive risk. Indeed, nominal rates were the lowest in almost four decades and below rates in many countries while real rates were negative. Recent theoretical work has modelled how changes in short-term interest rates may affect credit and liquidity risk-taking by financial intermediaries. Indeed, lower short-term interest rates may reduce the threat of deposit withdrawals, and improve banks liquidity and net worth, allowing banks to relax their lending standards and to increase their credit and liquidity risk-taking. Finally, low short-term interest rates make riskless assets less attractive and may lead to a search-for-yield by those financial institutions that have short time horizons. Concurrent with these theoretical developments, recent empirical work in progress has begun to study the impact of monetary policy on credit risk-taking by banks.

Identification strategy consists of two crucial components:

1. Interacting the overnight interest rate with bank capital (the main theory-based measure of bank agency problems) and a firm credit-risk measure.

3. Including in all key specifications – and concurrent with the short-term rate – also the ten-year government-bond interest rate, in particular in a triple interaction with bank capital and a firm credit risk measure.

There are a number of natural extensions to these studies. Our focus on the impact of monetary policy on individual loan granting overlooks the correlations between borrower risk and the impact on each individual bank’s portfolio or the correlations between all the banks’ portfolios and the resulting systemic-risk impact of monetary policy. In addition, both studies focus on the effects of monetary policy on the composition of credit supply in only one dimension, ie, firm risk. Industry affiliation or portfolio distribution between mortgages, consumer loans and business loans for example may also change. Given the intensity of agency problems, social costs and externalities in banking, banks’ risk-taking – and other compositional changes of their credit supply for that matter – can be expected to directly impact future financial stability and economic growth.

DESTABILISING MARKET FORCES

 

The structure of banks going forward


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