Bank Risk Taking, Monetary Policy, and the Business Cycle

One of the narrative explanations of the credit boom preceding the recent financial crisis and the Great Recession is that financial intermediaries took excessive risks because central banks kept interest rates too low for too long. On the one hand, loose monetary policy lowers the wholesale funding costs of banks and other financial intermediaries, incentivizing higher leverage and thus higher risk on the liability side of their balance sheets. On the other hand, low policy rates might also induce banks to lower their lending standards, effectively granting more loans to ex-ante riskier borrowers. Recent empirical research based on microeconomic bank-level data has shown that lower overnight interest rates indeed induce some banks to commit larger loan volumes with fewer collateral requirements to riskier firms. In Afanasyeva and Güntner (2014), we provide robust macroeconomic evidence for this risk channel of monetary policy in the aggregate U.S. banking sector. We then reformulate a partial-equilibrium debt contracting problem in order to allow for an active role of the bank. By incorporating the resulting optimal debt contract in a New Keynesian DSGE model, we show that expansionary monetary policy shocks lead to a temporary increase in bank lending relative to borrower collateral and thus a riskier loan portfolio of the banking sector as a whole, consistent with our empirical results. In Afanasyeva and Güntner (2014), we assume that the bank is sufficiently well capitalized to absorb non-performing loans in all states of the world without any effect on its depositors. However, our theoretical result that the bank finds it optimal to lower its lending standards in response to a monetary expansion, although its borrowers become more leveraged and thus more likely to default, ignores potential externalities of this individually optimal behavior. In this research project, I therefore plan to forgo the assumption that banks are sufficiently well capitalized to remain solvent in all states of the world, instead allowing for bankruptcies. Assuming that defaulting banks enjoy limited liability introduces an externality in financial intermediation that will be amplified by explicit deposit insurance, as in Austria, for example, or an implicit bailout guarantee by the government. The reason is that banks are no longer required to compensate their depositors for the risk of bankruptcy if deposits are insured and therefore an effectively risk-free asset from the savers` perspective. As a result, the banking sector as a whole will grant excessive credit, which raises the borrowers leverage ratio and its own exposure to fluctuations in aggregate productivity. Hence, the externality in financial intermediation creates a role for so-called macro-prudential regulation, such as a minimum capital requirement in the spirit of the Basel Accords. 1