Discussion paper: Monetary policy can increase banks' risk appetite

Excessive levels of risk in financial sector balance sheets led to the outbreak of the financial crisis in 2008. Since then, one of the questions economists have been investigating is the extent to which monetary policy played a part in this development. An important starting point in this respect is referred to as the risk-taking channel, which describes the mechanism by which low interest rates induce financial institutions to make riskier investments. In a discussion paper just published by the Bundesbank Research Centre, Angela Abbate, a member of the Research Centre staff, and Dominik Thaler of the European University Institute, examine this risk-taking channel.

By analysing US time series, Abbate and Taler show, first of all, that a risk-taking channel actually exists, meaning that changes in key interest rates do also affect banks' risk-taking behaviour. Using what is known as a dynamic equilibrium model, the authors then go on to explore the extent to which monetary policy measures produce a change in banks' asset risk.

Incentive to incur risk

In the model, banks collect capital from their owners and their customers (ie depositors) in order to fund investment projects. The bank has an information advantage over its customers in that it alone decides which project it funds and at what risk. The riskier the project is, the higher the potential rate of return will be. If the investment is successful, the bank benefits from the absence of a limit on the return, whereas its liability is limited to the capital it contributes. The depositors can neither observe nor influence their bank's investment decision. This has the effect of inducing banks to make excessively risky decisions.

Another factor which additionally strengthens a bank's risk appetite is that, when funding investment projects, the cost of the bank's equity is higher than the cost of customer deposits, as the equity may be lost in its entirety. Deposits, on the other hand, are protected up to a certain amount by deposit insurance schemes. For this reason, an equity premium is added to the interest rate for risk-free investments. The lower the overall interest rate level, the greater the effect of this premium in making equity more expensive in relation to deposits. Banks respond to this change by reducing their share of the funding. Their liability is also lowered as a result, increasing their excessive risk-taking in the funding of projects.

The discussion paper shows that funding through banks becomes less efficient overall under these assumptions, as the greater risk leads to a larger share of projects failing and, consequently, to a considerable decline in the capital stock.

Implications for monetary policy

The authors believe that the risk-taking channel leads to a loosening of monetary policy, ie an interest rate cut, amplifying the financial market distortions described above. This therefore dampens the intended positive effects of monetary policy loosening on output. To examine the extent to which central banks ought to take the risk-taking channel into account in their monetary policy deliberations, Abbate and Thaler test their model using empirical data from the USA. Their findings illustrate that the model fits the data well.

Finally, the authors use the model to analyse optimal monetary policy under the given conditions. To this end, they assume that the interest rate is the only available monetary policy instrument. According to their calculations, monetary policymakers ought to respond to the banks' risk-taking channel by stabilising the real interest rate. The authors argue that, by tolerating higher inflation fluctuations, the central bank would reduce welfare-detrimental fluctuations associated with the banks' risk decisions. The welfare gains of the central bank taking the risk-taking channel into account are found by the authors to be economically significant. Nevertheless, Abbate and Thaler also note that alternative measures, such as capital rules, may be better suited to remedying distortions in the funding of projects.

The main purpose of research conducted by the Bundesbank Research Centre is to develop and consolidate academic expertise in the fields of economics, banking and financial stability. Its findings support the Bundesbank's decision-making process and are a factor behind the Bank's excellent reputation in academic circles and with other policymaking institutions. The opinions expressed in discussion papers are those of the authors. They do not necessarily reflect the views of the Deutsche Bundesbank or its staff.