Lending Standards, Bank Risk-Taking, and Monetary Policy

Abstract

This paper contributes to the burgeoning literature on the so-called “risk-taking channel” of monetary policy by constructing a partial equilibrium model of the commercial loan market, where conventional monetary policy influences bank lending standards and, by extension, the risk of bank default. In the model, borrower heterogeneity in terms of entrepreneurial abilities and project revenue results in optimal commercial bank lending standards. These standards take the form of a minimum ability requirement: only borrowers with abilities greater than or equal to the minimum threshold receive a loan; the rest are completely excluded from the loan market. After loans are made, a negative aggregate shock that lowers all borrowers’ project revenue results in unexpected loan losses for the bank that may push it into default.

In the baseline model, lending standards loosen and the probability of bank default rises when the central bank’s policy rate falls, a result that suggests that asset quality and lending standards may play an important role in shaping the risk-taking channel of monetary policy. However, the relationship between bank default and the policy rate is sensitive to the extent of bank capitalization. While default risk and the policy rate are negatively correlated at relatively strongly capitalized banks, the risk of default at more weakly capitalized banks increases with the policy rate. Additionally, default risk at strongly capitalized banks is more responsive to changes in the policy rate than at weakly capitalized banks.

This paper contributes to the literature on the risk-taking channel of monetary policy. First, the model enables analysis of the impact of monetary policy on risk-taking in a setting where both bank asset quality and leverage play a role in shaping the risk of bank default. Second, the model’s results on the role of bank capitalization imply that the tradeoff between financial stability and monetary policy depends crucially on bank capital ratios. This suggests that recent changes to bank capital requirements embodied in new post-2008 financial crisis regulations may impact the nature and size of the risk-taking channel.