Banks’ Risky Behaviour and Failures Led by Low Interest Rates – Study: UC Davis Graduate School of Management

J. P. Morgan & Co. Building panorama

J. P. Morgan & Co. Building panorama (Photo credit: epicharmus)

A new University of California, Davis, study says that the low interest rate environment that prevailed throughout most of the 2008 financial crisis period was likely an important determinant of that risky behaviour of significantly expanding loan portfolios, often by extending loans to risky customers, and financing themselves primarily with debt. This led to the avalanche of bank failures as banks’ loans failed to repay.

“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,” said Robert S. Marquez, a professor at the UC 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.”

The research establishes a link between interest rates and the risk-taking decisions by banks. In particular, it 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. 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.

Managerial Implication

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,” said Professor Marquez.

The research is scheduled to be published in the Journal of Economic Theory.

From: U C Davis

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