Does lowering monetary policy rates increase risk-taking in the financial sector?

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Nuno Coimbra and Hélène Rey

In the aftermath of the great financial crisis, the question of excessive risk-taking by banks and other financial intermediaries became very important in the minds of policy makers and academics alike. Understanding its causes and origins is essential in designing adequate regulations, since risk is also a fundamental and inherent aspect of the financial sector. One important concern is understanding whether monetary policy affects risk-taking in the financial sector and also when and how the two are linked. Did the period of historically low rates before the crisis worsen financial stability? Is the current low interest rate environment also leading to the build-up of systemic risk?

In this paper, Nuno Coimbra and Hélène Rey look at how competition between different financial intermediaries can generate a strong connection between policy rates and financial stability. Interest rates affect the composition of the financial sector and how assets are distributed between riskier and less risky financial intermediaries.

When interest rates become very low, riskier financial intermediaries find it very cheap to grow using leverage and can push safer, more conservative ones out of risky financial markets. For example, a cautious bank who wanted to provide mortgages during the boom might find it hard to compete with a neighboring bank which is willing to provide No-Income-No-Job-no-Assets (NINJA) mortgages at very cheap rates. As the name suggests, these were very risky mortgages where the lender did not even require the borrower to provide any information on their job, income or wealth. The easier it is for the riskier bank to find cheap funds to provide these mortgages, the harder it will be for the conservative bank to find clients for his own mortgages. This means that low interest rate environments can lead to lower financial stability through its effect on the composition of the financial sector.

A macroeconomic model with heterogeneous financial intermediaries helps clarify the full effect of interest rates on the composition of the financial sector. When interest rates fall, there are two competing effects. The first, already explained above, means that competition for financial assets drives up asset prices and decreases expected returns, which can lead to a decrease in the market share of safer banks and financial intermediaries. This leaves the financial sector more concentrated into riskier, highly-levered intermediaries generating low risk-premia and higher systemic risk. The second effect works through the cheaper cost of liabilities. If the cost of liabilities falls, then more conservative intermediaries might find it now worthwhile to increase their holdings of risky assets and so the market becomes less concentrated and financial stability is improved. The first effect tends to dominate when interest rates are already low to begin with, while the second one dominates for environments with higher rates. So an expansionary monetary policy worsens financial stability in low interest rate environments, but can actually improve it when rates are high to begin with.

In conclusion, when interest rates are not very low, central banks who need to stimulate the economy do not face any trade-off in terms of financial stability. But when interest rates are already low, further cuts might come at a cost in terms of systemic risk and central banks would do well to recognize this.

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Original article: Financial Cycles with Heterogeneous Intermediaries
Published in: NBER Working Paper No. 23245 - Issued in March 2017, Revised in January 2019
Available at: https://www.nber.org/papers/w23245