Bank Leverage and Monetary Policy's Risk‐Taking Channel: Evidence from the United States

• DOI: http://doi.org/10.1111/jofi.12467
• Author: LUC LAEVEN,GIOVANNI DELL'ARICCIA,GUSTAVO A. SUAREZ
• Date: 01 April 2017
• Published date: 01 April 2017

THE JOURNAL OF FINANCE •VOL. LXXII, NO. 2 •APRIL 2017

Bank Leverage and Monetary Policy’s

Risk-Taking Channel: Evidence

from the United States

GIOVANNI DELL’ARICCIA, LUC LAEVEN, and GUSTAVO A. SUAREZ∗

ABSTRACT

We present evidence of a risk-taking channel of monetary policy for the U.S. banking

system. We use confidential data on banks’ internal ratings on loans to businesses

over the period 1997 to 2011 from the Federal Reserve’s Survey of Termsof Business

Lending. We find that ex ante risk-taking by banks (measured by the risk rating of

new loans) is negatively associated with increases in short-term interest rates. This

relationship is more pronounced in regions that are less in sync with the nationwide

business cycle, and less pronounced for banks with relatively low capital or during

periods of financial distress.

THE GLOBAL FINANCIAL CRISIS has reignited the debate on the link between short-

term interest rates and bank risk-taking, also known as monetary policy’s “risk-

taking” channel—the notion that interest rate policy affects the quality,not just

the quantity,of bank credit.1Specifically, many hold the view that interest rates

∗Giovanni Dell’Ariccia is Deputy Director in the Research Department, International Monetary

Fund and CEPR Research Fellow. Luc Laeven is Director-General of the Directorate General

Research of the European Central Bank and CEPR Research Fellow. Gustavo A. Suarez is Chief

of Capital Markets Section, Research and Statistics, Federal Reserve Board. We are thankful to

Ken Singleton (the Editor), an anonymous Associate Editor, an anonymous referee, Tobias Adrian,

William Bassett, Olivier Blanchard, Francisco Covas, Hans Degryse, Burcu Duygan-Bump, Mark

Gertler,Robin Greenwood, Kose John, Anil Kashyap, Aart Kraay, Nellie Liang, David Lucca, Maria

Soledad Martinez Peria, Robert Marquez, Steven Ongena, Ali Ozdagli, Teodora Paligorova, Jose

Luis Peydro, Ricardo Reis, Kasper Roszbach, Joao Santos, David Scharfstein, Philipp Schnabl,

Steve Sharpe, Hyun Shin, Andrei Shleifer, Jeremy Stein, Ren´

e Stulz, Lars Svensson, Fabian

Valencia, Skander Van Den Heuvel, and Tomasz Wieladek; seminar participants at the NBER

Summer Institute, the University of Chicago, the European Central Bank, the Federal Reserve

Board, the Federal Reserve Bank of New York, the Federal Reserve Bank of Atlanta, the World

Bank, the LACEA Annual Meetings in Mexico City,the Central Bank of Brazil, the IBEFA Annual

Meetings, the European Finance Association Annual Meetings, the CSEF conference on bank

performance, financial stability,and the real economy in Naples; the 2014 Rising Stars conference

at Fordham University for useful comments on previous drafts of this paper; and to Scott Aubuchon,

Suzanne Chang, Roxana Mihet, and Joe Saia for excellent research assistance. The views expressed

here are those of the authors and not those of the European Central Bank, Federal Reserve Board,

Federal Reserve System, IMF,or IMF Board. The authors have no conflicts of interest, as identified

in the Disclosure Policy.

1Financial accelerator models, while considering credit risk, have little to say about the implica-

tions of changes in interest rates on bank risk-taking. In these models, monetary policy tightening,

DOI: 10.1111/jofi.12467

613

614 The Journal of Finance R

were held too low for too long in the run-up to the crisis (Taylor (2009)), and

that this helped fuel an asset price boom, spurring financial intermediaries to

increase leverage and take on excessive risks (Borio and Zhu (2008), Adrian and

Shin (2009,2010), Acharya and Naqvi (2012)). More recently, a related debate

has ensued on whether continued exceptionally low interest rates (including

because of unconventional monetary policy measures) are setting the stage for

the next financial crisis (e.g., Krishnamurthy and Vissing-Jorgensen (2011),

Farhi and Tirole (2012), Chodorow-Reich (2014)). More generally, there is a

lively debate about the extent to which monetary policy frameworks should

include financial stability considerations (Woodford (2012), Stein (2014)).

Theory offers ambiguous predictions on the relationship between real inter-

est rates and bank risk-taking. Traditional portfolio allocation models predict

that an exogenous increase in interest rates will reduce risk-taking. A higher

interest rate on safe assets leads to a reallocation from riskier securities toward

safe assets, thus reducing the riskiness of the overall portfolio (Fishburn and

Porter (1976)). At the same time, an increase in the risk-free rate may also

affect the composition of the pool of risky securities. In particular, assuming

that investment projects have limited scalability, a higher risk-free rate raises

the hurdle rate for investment and induces agents to cut projects that have

low return or/and high risk, with an ambiguous impact on the riskiness of the

investment pool (Chodorow-Reich (2014)).

Risk-shifting models of monetary policy, in contrast, predict a positive rela-

tionship between interest rates and bank risk-taking. In these models, asym-

metric information between banks and their borrowers prevents bank creditors

(and depositors) from pricing risk at the margin. This friction together with lim-

ited liability leads banks to take excessive risk. As a result, an increase in the

interest rate that banks have to pay on deposits will exacerbate the agency

problem associated with limited liability and inefficiently increase bank risk-

taking. The strength of this risk-shifting effect depends on the leverage/capital

of banks: it is expected to be the strongest for the least capitalized banks. These

banks are more exposed to agency problems, which become more severe when

interest rates are higher and their intermediation margins are compressed

(see, for instance, Stiglitz and Weiss (1981), Hellmann, Murdock, and Stiglitz

(2000), Acharya and Viswanathan (2011)). Thus, in traditional risk-shifting

models, the least capitalized banks are most sensitive to interest rate changes.

Since the relationship between the interest rate and bank risk-taking is

opposite under the traditional portfolio allocation model and the risk-shifting

model, the two effects partly offset each other in models that take both into

account (Dell’Ariccia, Laeven, and Marquez (2014)). Specifically, Dell’Ariccia,

Laeven, and Marquez (2014) find that the effect of changes in risk-free rates

by increasing risk-free interest rates, leads to more severe agency problems by depressing bor-

rowers’ net worth (Bernanke and Gertler (1989), Bernanke, Gertler, and Gilchrist (1996)). The

resulting equilibrium is one in which firms and banks more affected by agency problems find it

harder to obtain external financing as more credit goes to firms with higher net worth. These

models have little to say about overall credit risk in the system—while agency problems increase

across the board, the marginal firm obtaining financing is of relatively better quality.

Bank Leverage and Monetary Policy’s Risk-Taking Channel 615

on bank risk-taking depends on the extent to which banks are able to pass

these changes on to lending rates as well as on how they optimally adjust

their capital structure in response to such changes (the Appendix presents a

simplified version of this model). The pass-through effect acts through the asset

side of a bank’s balance sheet. A reduction in the reference real interest rate

is reflected in a reduction of the interest rate on bank loans. This, in turn,

reduces the bank’s gross return conditional on its portfolio repaying, reducing

the incentive for the bank to monitor. Since the strength of the risk-shifting

effect is a function of leverage, the impact of monetary policy on risk-taking

will be mediated by the degree of bank capitalization. And since the two effects

tend to offset each other, the risk-taking of better capitalized banks will be

more sensitive to changes in interest rates.

Along the same lines as the risk-shifting channel, but going in the opposite

direction, there could be a “search for yield” effect for financial intermediaries

with long-term liabilities and short-term assets (i.e., negative maturity mis-

matches), such as life insurance companies and pension funds (Rajan (2005),

Dell’Ariccia and Marquez (2013)).2These financial intermediaries may be in-

duced to switch to riskier assets with higher expected yields when monetary

easing compresses their margins by lowering the yield on their short-term as-

sets relative to that on their long-term liabilities, and this effect should be most

pronounced for the least capitalized financial institutions.3

The above discussion suggests that the net effect of interest rates on bank

risk-taking, and its interaction with bank leverage, is an empirical question. A

more negative effect for highly capitalized banks would be consistent with the

classical risk-shifting effect, while a more negative effect for poorly capitalized

banks would be consistent with a search for yield effect.

In this paper,we study the link between short-term interest rates, bank lever-

age, and bank risk-taking using confidential data on individual U.S. banks’

loan ratings from the Federal Reserve’s Survey of Terms of Business Lending

(STBL).4We find that bank risk-taking as measured by the risk ratings of the

bank’s loan portfolio is negatively associated with short-term interest rates, as

proxied by the federal funds rate.5Further, consistent with the classical risk-

taking channel, we find that this negative relationship is more pronounced for

highly capitalized banks. Our empirical analysis shows that, for the typical new

2This is at odds with the notion that banks’ liabilities tend to have shorter maturities than

banks’ assets.

3Similarly, expectations of accommodative monetary policy following systemic liquidity crises

could encourage banks to increase leverage and fund more illiquid projects ex ante, thus increasing

inefficient risk-taking (Diamond and Rajan (2012)).

4STBL data have been used to study the determinants of risk-taking in bank loans, including

how it varies over the cycle, but not to test its relationship with monetary policy conditions (see,

for instance, Asea and Blomberg (1998), Carpenter, Whitesell, and Zakrajˇ

sek (2001), Black and

Hazelwood (2013)).

5Our focus is on short-term interest rates. Current monetary policy, by setting the policy rate,

has a direct effect only on short-term real interest rates; its effect on long-term interest rates

depends on the degree to which the conduct of monetary policy affects inflationary expectations,

and more generally on markets’ expectations of monetary policy in the future.