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"Prior to the crisis, few expected that low interest rates for extended periods were problematic and could have led to bank failures as there was very little, if any, guidance on this issue," explains Robert S. Marquez. (Credit: /\ \/\/ /\/Flickr)

economics

Low interest rates fueled banks’ risky loans

In the decade leading to the 2008 financial crisis, low interest rates likely encouraged banks to lend to risky customers, a new study finds.

“It wasn’t until after the crisis that people, including policymakers as well as academic economists, started realizing that the level of interest rates may induce particular bank behavior,” says Robert S. Marquez, a professor at the University of California, Davis Graduate School of Management. “Prior to the crisis, few expected that low interest rates for extended periods were problematic and could have led to bank failures as there was very little, if any, guidance on this issue.”

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The paper establishes a link between interest rates and the risk-taking decisions by banks. In particular, the paper shows that reductions in real interest rates, such as occur as part of a monetary expansion, lead banks to increase their leverage and expand their loan portfolio. The study, which is scheduled to be published in the Journal of Economic Theory, is available online at ScienceDirect.

In addition, the expansion in lending is primarily to borrowers who are less likely to repay their loans in full. This makes the bank itself riskier and more prone to failure.

Marquez says strict enforcement of strong equity-to-debt ratios could help forestall a crash in a weak economy being stimulated by monetary policy, but it might be unnecessarily restrictive in a good economy where capital forbearance would help solvent banks remain afloat.

“To the extent, however, that low interest rate periods may sow the seeds of future crises, care needs to be taken in balancing the two objectives of price and financial stability,” he says.

Marquez and his co-authors plan future research into how monetary policy might prevent excessive risk-taking that could have led to some bank failures.

Source: UC Davis

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