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...ithin a given time horizon (typically one year). 6 EDF is a well-known, forward-looking indicator of credit risk, computed by Moody’s KMV, which builds on Merton’s model to price corporate bond debt (=-=Merton, 1974-=-). 7 The EDF value, expressed as a percentage, is calculated combining banks’ financial statements with stock market information and a default database. EDF figures are regularly used by financial ins...

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... nominal rates of return. And a similar mechanism could be in place whenever private investors use short-term returns as a way of judging manager competence and withdraw funds after poor performance (=-=Shleifer and Vishny, 1997-=-; Brunnermeier and Nagel, 2004). More broadly, the link between low interest rates and excessive risk-taking is also influenced by competition, the structure of managerial bonus schemes and deficienci...

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...itude to risk (see the third column of Table 7). The variable SSICI controls for elements of structural irrationality or other behavioral attitudes on the side of investors, such as herding behavior (=-=Barberis et al., 1998-=-; Brunnermeier and Nagel, 2004). 19 17 The variables MP and BEL were also initially included in isolation in equation (7) but turned out not to be significant. Therefore we have decided to drop them f...

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...etary policy and risk-taking: theory and evidence From a historical perspective, easy monetary conditions are a classical ingredient in boombust type business fluctuations (Fisher, 1933; Hayek, 1939; =-=Kindleberger, 1978-=-). Low interest rates could indeed induce financial imbalances by means of a reduction in risk aversion of banks and other investors. This part of the monetary transmission mechanism has been recently...

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...vestors’ risk aversion. This mechanism is in line with the findings from literature on asset-pricing models, which predict higher credit spreads in the long run after periods of lower interest rates (=-=Longstaff and Schwartz, 1995-=-; Dufresne et al., 2001). Finally, risk-taking may also be influenced by the communication policies of a central bank and the characteristics of policymakers’ reaction functions. For example, a high d...

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...ts for �GDPN are negative. Better economic conditions increase the number of projects becoming profitable in terms of expected net present value, thereby reducing the overall credit risk of the bank (=-=Kashyap et al., 1993-=-). Higher output growth reduces credit risk on both new and outstanding loans, in stark contrast to the differential effects of monetary policy. Furthermore, the coefficients for the slope of the yiel...

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...echanism is in line with the findings from literature on asset-pricing models, which predict higher credit spreads in the long run after periods of lower interest rates (Longstaff and Schwartz, 1995; =-=Dufresne et al., 2001-=-). Finally, risk-taking may also be influenced by the communication policies of a central bank and the characteristics of policymakers’ reaction functions. For example, a high degree of central bank p...

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...become less risk-averse during economic expansions because their 4 This is close in spirit to the familiar financial accelerator, in which increases in collateral values reduce borrowing constraints (=-=Bernanke et al, 1996-=-). Adrian and Shin (2009b) claim that the risk-taking channel is distinct but complementary to the financial accelerator because it focuses on amplification mechanisms due to financing frictions in th...

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...to a certain credit event (usually a default), has been widely used during the recent credit crisis as the barometer of financial health and an early indicator of banks’ problems (Blanco et al, 2005; =-=Longstaff et al, 2005-=-). Results for an unbalanced sample of more than 100 large banks over the period 2002-2009 obtained from Bloomberg were also consistent with those obtained by using the EDF and idiosyncratic measure o...

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...n of these variables accounts for the effects of the standard ‘financial accelerator’ mechanism, through which financing frictions on firms and households amplify or propagate exogenous disturbances (=-=Bernanke and Gertler, 1989-=-). With a given bank risk aversion (or tolerance), the coefficients of both variables should be negative: a boost in asset prices increases the value of collateral and reduces overall credit risk. How...

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...ncentives for banks, asset managers and insurance companies to take on more risk for behavioral, contractual or institutional reasons, for example to meet a nominal return target (Brunnermeier, 2001; =-=Rajan, 2005-=-). In this paper we analyze empirically the relationship between monetary policy and risk-taking by banks. Using a unique database of quarterly balance sheet information and risk measures for listed b...

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...ses in taming higher levels of inflation strengthened the support for a large number of monetary authorities to lower interest rates, keeping them below the levels suggested by historical experience (=-=Taylor, 2009-=-). While excessive liquidity could encourage bank risk-taking, this financial stability aspect was not seen as particularly threatening for two main reasons. First, most central banks around the world...

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...nd a similar mechanism could be in place whenever private investors use short-term returns as a way of judging manager competence and withdraw funds after poor performance (Shleifer and Vishny, 1997; =-=Brunnermeier and Nagel, 2004-=-). More broadly, the link between low interest rates and excessive risk-taking is also influenced by competition, the structure of managerial bonus schemes and deficiencies in supervision and regulati...

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...acteristics that summarize the ability and willingness of banks to supply additional loans (Ehrmann et al., 2003). We have, therefore, introduced into the specification SIZE (the log of total assets; =-=Kashyap and Stein, 1995-=-), LIQ (securities and other liquid 9assets over total assets; Stein, 1998); and CAP (the capital-to-asset ratio; Kishan and Opiela, 2000; Van den Heuvel, 2002). The econometric model is therefore mo...

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...roduced into the specification SIZE (the log of total assets; Kashyap and Stein, 1995), LIQ (securities and other liquid 9assets over total assets; Stein, 1998); and CAP (the capital-to-asset ratio; =-=Kishan and Opiela, 2000-=-; Van den Heuvel, 2002). The econometric model is therefore modified in the following way: �EDF i, t � ��EDF � 1 � j�0 j �� SIZE i, t �1 � SLOPE i, t �1 � 1 � j�0 k, t � j j �� LIQ � �MP � 1 � j�0 i, ...

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...k insurance subject to a certain credit event (usually a default), has been widely used during the recent credit crisis as the barometer of financial health and an early indicator of banks’ problems (=-=Blanco et al, 2005-=-; Longstaff et al, 2005). Results for an unbalanced sample of more than 100 large banks over the period 2002-2009 obtained from Bloomberg were also consistent with those obtained by using the EDF and ...

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...ans (Ehrmann et al., 2003). We have, therefore, introduced into the specification SIZE (the log of total assets; Kashyap and Stein, 1995), LIQ (securities and other liquid 9assets over total assets; =-=Stein, 1998-=-); and CAP (the capital-to-asset ratio; Kishan and Opiela, 2000; Van den Heuvel, 2002). The econometric model is therefore modified in the following way: �EDF i, t � ��EDF � 1 � j�0 j �� SIZE i, t �1 ...

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...er than the baseline estimation (0.6% in the first column of Table 5). Historically, most systemic banking crises have been preceded by periods of excessive lending growth (Reinhart and Rogoff, 2008; =-=Borio and Drehmann, 2009-=-). Therefore, it would be interesting to test whether the risk-taking channel continues to work at the level of individual banks, even when controlling for the effect on banking risk due to excessive ...

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...ociated with �MP and the TGAP measure have the correct sign, but are no longer always significant). This could be due to the implementation of ratings downgrades, as observed during the Asian crisis (=-=Ferri et al., 1999-=-). Testing for non-linear effects, business expectations and regulatory differences The recent crisis has reminded us of the fact that the manifestation of risk may be sudden and not linear. This sect...

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...l holds controlling for the fact that most of the banks in the sample have relied heavily on the securitization market and might have simply reduced monitoring and screening on their loan portfolios (=-=Parlour and Plantin, 2007-=-). Drucker and Puri (2007) show that securitized loans tend to be less informationally sensitive than loans held by banks, i.e. banks sell loans such as mortgages for which screening and monitoring ar...

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...of low interest rates Controlling for changes in business expectations (Consensus Forecast) Controlling for changes in risk appetite (State Street Investor Confidence Index) Difference in regulation (=-=Barth et al., 2004-=-) Coeff. S.Error Coeff. S.Error Coeff. S.Error Coeff. S.Error �EDF t-1 0.203 *** 0.007 0.242 *** 0.008 0.244 *** 0.007 0.240 *** 0.007 �MP t 0.070 0.068 0.262 *** 0.052 0.263 *** 0.057 0.241 *** 0.052...

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... The link between bank risk and accommodative monetary policy could also be influenced by balance sheet characteristics that summarize the ability and willingness of banks to supply additional loans (=-=Ehrmann et al., 2003-=-). We have, therefore, introduced into the specification SIZE (the log of total assets; Kashyap and Stein, 1995), LIQ (securities and other liquid 9assets over total assets; Stein, 1998); and CAP (th...

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...esponses from the Bank Lending Survey for euro area banks and Senior Loan Officer Survey for US banks regarding the effect of competition on credit conditions to construct a net percentage index (see =-=Ciccarelli et al., 2010-=-). This index, representing the difference between the number of banks that reported a tightening in credit conditions due to competition and the number that reported an easing, was used in the regres...

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...esting because downgrades in ratings are sluggish and take a long time to occur. This, for example, seems to have been the case for the rating of securitized products during the recent credit crisis (=-=Benmelech and Dlugosz, 2009-=-). The robustness test, therefore, used the banks’ standard long-term senior unsecured rating history and ratings outlook, calculated by Moody’s and available for a sub-sample of 149 banks, as a depen...

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... which is significantly lower than the baseline estimation (0.6% in the first column of Table 5). Historically, most systemic banking crises have been preceded by periods of excessive lending growth (=-=Reinhart and Rogoff, 2008-=-; Borio and Drehmann, 2009). Therefore, it would be interesting to test whether the risk-taking channel continues to work at the level of individual banks, even when controlling for the effect on bank...

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...the main conclusions. 1Monetary policy and risk-taking: theory and evidence From a historical perspective, easy monetary conditions are a classical ingredient in boombust type business fluctuations (=-=Fisher, 1933-=-; Hayek, 1939; Kindleberger, 1978). Low interest rates could indeed induce financial imbalances by means of a reduction in risk aversion of banks and other investors. This part of the monetary transmi...

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... and excessive risk-taking is also influenced by competition, the structure of managerial bonus schemes and deficiencies in supervision and regulation (Ackerman et al., 1999; Salas and Saurina, 2003; =-=Kouwenberg and Ziemba, 2007-=-). A third possible set of effects of monetary policy on risk-taking may operate through habit formation. In their work on the equity risk premium, Campbell and Cochrane (1999) show that investors bec...

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...ers instead of one quarter under the hypothesis that the market needs at least one year to detect a significant deviation of the credit portfolio of a given bank with respect to the industry average (=-=Jiménez and Saurina, 2006-=-). Similar results are obtained using the loan to total asset ratio instead than the lending growth rate. Estimations are available from the authors upon request. 11It is worth noting that the increa...

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...loans and the predictions of Dubecq et al. (2009). The drop in the EDF is probably reinforced by the reduction in bank funding liquidity cost after the decrease in short-term monetary interest rates (=-=Diamond and Rajan, 2009-=-; Adrian and Shin, 2009a). The coefficient related to the TGAP variable is negative and significant, confirming the effect of a risk-taking channel: if the interest rate is below the benchmark rate, b...

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... for the countries in the sample is reported in Chart 1. Even if EDFs have done quite well as a predictor of default during the recent credit crisis with respect to other measures (see, for instance, =-=Munves et al., 2009-=-), Chart 1 shows that risk had probably been underpriced in the pre-crisis period. 8 This means that prior to the crisis banks were taking risks which were not fully accounted for by financial market ...

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...in ways in which low interest rates may influence bank risk-taking. First, low interest rates affect valuations, incomes and cash flows, which in turn can influence how banks measure risk (Adrian and =-=Shin, 2009-=-a; 2009b; Borio and Zhu, 2008). Second, low returns on investments, such as government (riskfree) securities, may increase incentives for banks, asset managers and insurance companies to take on more ...

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...ex securities (Panetta et al., 2009). Moreover, it has often been pointed out that these big banks in financial difficulties could have been “too big to be saved by their national governments alone” (=-=Stiglitz, 2009-=-). In order to check if the result on the size variable is driven by these effects during the crisis, the model has been adapted by including an interaction between the variable SIZE and a crisis dumm...

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...004). Second, financial innovation had, for the most part, been regarded as a factor that would strengthen the resilience of the financial system by resulting in a more efficient allocation of risks (=-=Greenspan, 2005-=-). In this context, the financial stability implications of monetary policy actions were deemed of minor importance. Although it is difficult to state that monetary policy has been the main cause of t...

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...ties, may increase incentives for banks, asset managers and insurance companies to take on more risk for behavioral, contractual or institutional reasons, for example to meet a nominal return target (=-=Brunnermeier, 2001-=-; Rajan, 2005). In this paper we analyze empirically the relationship between monetary policy and risk-taking by banks. Using a unique database of quarterly balance sheet information and risk measures...