The summer of 2007 was hot for financial markets and central banks. Troubles in the credit markets negatively affected banks, liquidity evaporated in the interbank markets and central banks intervened on a scale not often seen before. Many market observers immediately argued that during the long period of low interest rates, stretching from 2001 to 2005, banks softened their lending standards and loaded up on excess risk. During the crisis many market participants, nevertheless, clamoured for central banks to reduce the interest rates again to alleviate their financial predicament.
Hazardous times for monetary policy indeed: on the one hand, low interest rates may create excessive risk-taking; on the other hand, low interest rates may reduce the risk of outstanding bank credit. In this paper we provide the first hard evidence on this treacherous dilemma by answering the following questions: Do low interest rates encourage bank risk-taking, but at the same time reduce credit risk on outstanding loans? What is the impact of the stance and path of monetary policy on credit risk? And, do monetary and output changes have a similar effect on bank risk?
Though the effects of monetary policy on the volume of credit in the economy have been widely studied (see e.g. Bernanke and Blinder (1992), Bernanke and Gertler (1995), Kashyap and Stein (2000)), its effects on the composition of credit, in particular on the riskiness of borrowers, have not yet been empirically explored. On the basis of recent theoretical work we can understand how changes in short-term interest rates may affect risk-taking in financial institutions. Matsuyama (2007) for example shows that an increase of the borrowers’ net worth (through a decrease in interest rates e.g.) reduces agency costs thus making financiers more willing to lend to riskier borrowers (with less access to pledgeable assets). Low borrowers’ net worth, on the other hand, may impel financiers to flee to quality (Bernanke, Gertler and Gilchrist (1996)). Low interest rates may also abate adverse selection problems in the credit markets, causing banks to relax their lending standards and increase their risk-taking (Dell'Ariccia and Marquez (2006)). In general, low interest rates make riskless assets less attractive for financial institutions increasing their demand for riskier assets with higher expected returns (Rajan (2006)).
We study the impact of the stance and the path of monetary policy on the risk-taking and loan credit risk of banks. For econometric identification, exogenous monetary policy and comprehensive data on individual bank loans are needed. The Credit Register of the Bank of Spain is uniquely suited. The Register contains detailed monthly information on virtually all, new and outstanding, commercial and industrial loans by all credit institutions in Spain during the last twenty-two years – generating almost twenty-three million bank loan records in total. The Register also contains essential information on lending standards and loan performance that are key to our analysis. Spanish monetary conditions were exogenously determined during this period, initially from 1988-98 through a policy that aimed at a fixed exchange rate with the Deutsche Mark, as of 1999 within the Eurosystem. For this reason we use the German then Euro overnight interbank rates as our measure of monetary policy stance.
Using a variety of duration models and controlling for bank, firm, loan and macroeconomic characteristics, we analyse how short-term interest rates prior to loan origination and during the life of the loan affect the loan hazard rate (default probability per unit of period). We find that the hazard rate increases with lower interest rates at loan origination but also increases as a result of higher rates during the life of the loan.
