Economics Assignment 1
Are low monetary policy rates good or bad for financial stability? Discuss in detail and support your answer with reference to empirical research by Jiminez et al. (2013) and Maddaloni and Peydro-Alcalde (2011) in this area.
Solution:
Low monetary policy rates are being blamed by observers for the build up of the recent financial crisis.
Expansive monetary policy (effect of low interest rates) results in:
- Softening standards by banks.
- Taking excessive risks.
- Higher volume of credit.
- Changes in composition of credit (composition pool of borrowers).
- Agency problem (i.e., low levels of capital due to increased writes-offs, reductions in investment).
- Improve banks’ liquidity and net worth.
- Riskless assets less attractive and may lead to a search-for-yield .
- Securitization enhances bank lending capacity and attractive returns.
- Monetary illusion to boost profits- inducing higher risk-taking to credit risk (i.e., loans with a higher probability of default).
- Increasing the yield curve slope (maturity mismatch) softens lending standards and exposure to liquidity risk.
- Reduce adverse selection problems in credit markets and decrease screening by banks.
- Foster bubbles in asset prices and credit.
- Increase opportunity cost to hold cash – risky investment more attractive.
- Reduce the banks’ net worth or charter value (i.e., “Gambling for resurrection” strategy more attractive).
Important! Market participants craved for low interest rates to alleviate their financial predicaments!
Jiménez et.al., (Econometrica 2013) study empirically the impact of short-term interest rates on the composition of the supply of credit (risk taking; i.e., impact on loan granting). They disentangle supply from demand of credit while accounting for short and long term interest rates using data from the Spanish credit register, bank-firm level data covering period 1984 to 2009.
Key findings:
- Key variable: interaction of bank capital, firm credit risk, and short-term interest rate changes.
- Positive coefficient on triple interaction implies more risk taking by lowly capitalized banks when interest rates decline (i.e., expanding and prolonging credit to riskier firms).
- Long term interest rates insignificant.
- Large banks loosen their lending standards for risky firms less than small banks.
- Process of extending credit driven by supply (banks) rather than demand (borrowers).
- Amplification of risk taking could be caused by financial innovation.
Maddaloni and Peydro-Alcalde (RFS 2011) ask whether low levels of short and long-term interest rates soften bank lending standards? Using data for the Euro area and the U.S. lending standards covering 1991 to 2008, they analyse the impact of both short- and long-term rates on lending standards directly and through the interaction with too low for too long monetary policy rates, securitization and banking supervision. They also investigate the relation between short-term rates and lending standards prior to the financial crisis and the economic, banking, and fiscal performance afterwards.
Key findings:
- One-standard-deviation decrease of Taylor rule residuals five time stronger than increase in softening due to increase of GDP (−13.68 per cent and −2.61 per cent, respectively).
- Monetary policy rates have an impact on lending standards almost double the impact of GDP growth (−11.48 per cent and −6.10 per cent, respectively).
- GDP growth not significant for consumer credit.
- Low short-term rates soften standards for all types of loans.
- Softening of lending standards amplified by too low for too long monetary policy rates.
- Softening of lending standards already due to low monetary policy amplified by securitization activity.
- Higher long-term rates soften lending standards for firms.
- Impact of low monetary rates on the softening of standards (due to bank balance-sheet constraints) for mortgage loans is amplified when supervision standards for bank capital are weak. Low levels of monetary policy rates increase bank loan risk-taking especially when banking supervision is weak.
- Countries with low monetary interest rates before the crisis, excessive financial innovation and weak supervision:
- Experienced worse economic performance after the crisis (measured by real fiscal and banking variables).
- Incurred higher costs towards recovery.
- Monetary policy rates affect financial stability.
