Monetary Policy in a Low Interest Rate Environment: Reversal Rate and Risk-Taking

Abstract

This paper develops a simple analytical framework to study the impact of central bank policy-rate changes on banks’ credit supply and risk-taking incentives. Unobservable expost bank monitoring of loans creates an external-financing constraint, which determines bank leverage. Unobservable, costly ex-ante screening of borrowers determines the level of bank risk-taking. More risk-taking tightens the external-financing constraint. The policy rate affects the external-financing constraint because it affects both the return on outside investors’ alternative investments and loan rates. In a low rate environment, a policy-rate cut reduces bank funding costs less because of a zero lower bound (ZLB) on retail deposit rates. Bank risk-taking is a necessary but not sufficient for a policy-rate cut to become contractionary ("reversal"). Reversal can occur even though banks’ net-interest margins increase. Credit market competition plays an important role for the interplay of monetary policy and financing stability. When banks have market power, a policy-rate cut can increase lending and still lead to risk-taking. We use our analytical framework to discuss the literature on how monetary policy affects the credit supply of banks, with special emphasis on low and negative rates. JEL Classification: E44, E52, E58, G20, G21