Risky Behavior of Central Banks: The Impact of Interest Rates on Lending Standards

There is disunity in the research community what kinds of low interest rates have an effect on the softening of lending standards. Some researchers suggest that both short-term and long-term low interest rates in combination with financial innovation and weak supervision lead to the softening of lending standards and increased bank risk taking. Maddaloni & Peydró disagree with the majority of researchers who believe that low long-term interest rates have caused the financial crisis. They state that 'low short-term rates were a key determinant of the last financial and economic crisis' and that the negative effect of low short-term interest rates has been further multiplied by a multitude of other factors. Maddaloni & Peydró, say 'When the risk materialized and the capacity of bank balance-sheets was impaired, banks started to reduce lending, thereby inducing a real and fiscal crisis'. As such, they come to the conclusion that the global financial crisis was indeed caused by banks taking on too many risks because short-term low interest rates had softened lending standards.

Macro level

The macro level describes all aspects on bank risk taking on the international or global levels. This section will shortly discuss the overall economic situation and focus on monetary policy as a main cause for bank risk taking that led to the financial crisis.

The overall economic situation

Bank risk is influenced by the macroeconomic environment of each country. Economic periods of recession or boom have different effects on bank risk taking.

In times of economic boom of the past decades, banks profited from substantial yields by increasing their risks. Central banks controled economic stability in such situations by increasing interest rates, which led to the decrease of bank leverage and risk taking and balanced out risk levels.

The situation in times of recession is somewhat different. Up until the financial crisis, low interest rates in combination with softening of lending standards and thus an increase in credits to borrowers has been perceived as positive. Banking experts believed that this approach would reactivate the economy, foster growth and spur prosperity. In the case of the global financial crisis, it has rather worsened the economic situation. This was also due to the fact that the relationship between low interest rates and bank risk behaviour is not yet fully understood. Dell'Ariccia & Marquez suggest a possible explanation: in extreme situations of crisis, monetary policy changes are not enough to balance out risk taking and price stability. This may lead to deflation as has happened in the recent crisis.

Monetary policy

The main objective of the European Central Bank (ECB) is to ensure price stability in the Euro zone. The Federal Reserve (FED) has a similar role in the US. The central banks control the availability of money in the economy and define interest rates. This is called the monetary policy. When the central bank injects money into the economy, interest rates fall - this is known as expansionary monetary policy. Prior to the global financial crisis, the central bank reacted to the burst of the dotcom bubble in 2000 by introducing lower interest rates in order to avoid recession. Keeping the interest rates too low for too long might have contributed to the global financial crisis in 2007.

De Nicolò et al. show that monetary policy has a direct effect on bank risk behaviour: Firstly, changes in interest rates affect bank profits and franchise value and may thus encourage increased risk taking. Secondly, the 'Greenspan put' has been observed in the banking sector where banks take higher risks ex-ante recession, because they assume that the central bank will reduce interest rates in the near future. Before the financial crisis, the central bank did not believe that their monetary policy, that mainly had the role to ensure price stability, could have an effect on bank risk behaviour. This understanding has changed after the financial crisis. Whereas the central bank controls the monetary policy, national agencies are responsible for bank supervision and financial stability. Those two responsibilities are independent from one another and were seen as not having any influence on each other – a believe that was proven wrong during the financial crisis. The financial crisis has made the central bank aware that it must consider bank supervision when making decisions affecting monetary policy without taking away the supervision responsibility from national authorities.

The time before the financial crisis was defined by expansionary monetary policy and has shown that low interest rates lead to increased bank risk behaviour. This shows that short-term low interest rates might have been one but not the only main cause of the financial crisis. High interest rates stimulate banks to become more risk-averse, because banking costs increase in times of economic boom and each asset potentially failing results in higher losses. De Nicolò et al. argue that the central bank could have prevented the financial crisis by raising interest rates at an earlier point than they did. Thus, monitory policy has a direct effect on financial stability. Prior to 2007, this relationship has often been neglected. Delis & Kouretas find that the ECB even more than the FED did not understand its policy decisions as a factor that could influence bank risk behaviour. Their main objective has always been to ensure price stability and not to supervise decision making of banks.

Conclusion

This paper discussed which aspects are considered major causes for bank risk taking and the global financial crisis in 2007. The most important findings are that the three factors management of the monetary policy by central banks, weak supervision of banks by national agencies, and low interest rates played a major role in creating risky bank behaviour.

The crisis has shown that central banks need to consider the policies of national banking supervision agencies when making decisions on the monetary policy. Effective supervision is provided by national agencies, but stands in direct connection with the economic environment that the central banks set. As such, policy makers should be more aware about the relationship between interest rates and bank risk taking, because their monetary policy changes have direct effects on financial systems. Also, the central bank needs to improve its transparency when it comes to their monetary policy. This would enable banks to make better predictions on the future development of money supply and thus reduce their level of risk taking. Therefore, central banks need a new approach that also takes into account bank risk behaviour to ensure a stable financial system when making monetary policy changes. This would contribute towards an improved financial stability.

Since research has shown that policy decisions of central banks and national bank supervision bodies have a direct relationship, organisational change is needed in supervision agencies as well as central banks. In the aftermath of the financial crisis, research has recommended strengthening the role of supervision agencies. Increased levels of regulation and supervision may lead to less risky bank behaviour. Regulations should be put in place to reduce information asymmetry and thus enable banking agents to make informed decisions on risk. This means banking supervision must consider monetary policy when monitoring bank behaviour. This would effectively result in centralising more responsibility and monitoring power over national supervision agencies into the central bank.

There is a consensus among researchers that low interest rates strongly increase the risk taking behaviour of banks. The cause-effect-relationship between interest rates and bank risk taking is very complex, especially when other economic factors are considered that influence the banking sector or individual banks. As such, findings suggest that there is a clear trend that too low interest rates below a certain threshold would increase bank risk behaviour, nevertheless the individual characteristics of the respective banks, the national context and the macroeconomic environment must be considered in relation to interest rates before statements can be made what caused banks to behave in a certain way.

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