Interest rates, capital and bank risk-taking

Staff working papers set out research in progress by our staff, with the aim of encouraging comments and debate.
Published on 21 December 2018

Staff Working Paper No. 774

By Jonathan Acosta-Smith

Are low interest rates more likely to incentivise greater bank risk-taking? This is the question we seek to answer. Using a model in which banks raise funds from depositors to create an investment portfolio which can differ in its risk and return, we suggest so. In particular, we show that lowering the interest rate makes it more likely banks will make risky investments. This is because reducing the interest rate makes safer assets less attractive, while increasing the relative gains from gambling. We show that risk-taking is highly dependent on banks’ skin-in-the-game, as banks always ignore the full extent of losses on bankruptcy. Raising the interest rate has a similar effect. It reinforces this behaviour, as by increasing the yield on the portfolio, banks have more to lose on bankruptcy.

PDFInterest rates, capital and bank risk-taking

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