Long periods of low interest rates make banks take more risks

Using a comprehensive database of listed banks from the EU and the US, Gambacorta finds strong evidence of a link between the two in the run up to the crisis. Banks’ risk of default implied by asset prices shot up by a larger amount in countries where interest rates had remained low for an extended period prior to the crisis, implying that monetary policy is not fully neutral from a financial stability perspective. Monetary policy may influence banks’ perceptions of, and attitude towards, risk in at least two ways: (i) through a search-for-yield process, especially in the case of nominal return targets, and (ii) by means of the impact of interest rates on valuations, incomes and cash flows, which, in turn, can modify how banks measure risk.Easy monetary conditions are a classic ingredient of financial crises: low interest rates contribute to an excessive expansion of credit and, hence, to boom-bust-type business fluctuations. In addition, some recent papers have found a significant link between low interest rates and banks’ risk-taking , pointing to a different dimension of the monetary transmission mechanism, the so-called risk-taking channel. This channel may operate in two ways. First, low returns on investments, such as government securities, may increase incentives for banks, asset managers and insurance firms to take on more risk for contractual or institutional reasons (for example, to meet a target nominal return). Second, low interest rates affect valuations, incomes and cash flows, which can modify how banks measure risk.
The inertia in nominal targets at a time of lower interest rates could be for a number of reasons, some psychological, such as money illusion. Investors may ignore the fact that nominal interest rates may decline to compensate for lower inflation. Others may reflect institutional or regulatory constraints. For example , life insurance companies and pension funds typically manage their assets with reference to their liabilities. In a period of declining interest rates, the interest rates on their liabilities may exceed the yields available on highly-rated government bonds. The resulting gap can lead institutions to invest in higher-yielding , higher-risk instruments. More generally, financial institutions regularly enter into long-term contracts committing them to produce relatively high nominal rates of return.The second way low interest rates can make banks take on more risk is through their impact on valuations, incomes and cash flows. A reduction in the policy rate boosts asset and collateral values, which, in turn, can modify bank estimates of probabilities of default, loss-given-default and volatilities.In the aftermath of the bursting of the dotcom bubble, many central banks lowered interest rates to combat recession. With inflation remaining remarkably stable, central banks in a number of developed countries kept interest rates below previous historical norms for some time. The implication of these strategies for risk-taking did not loom large in policy decisions. First, most central banks had progressively shifted to tight inflation objectives. Second, financial innovation was seen as a factor that would strengthen the resilience of the financial system, by resulting in a more efficient allocation of risk.
Nonetheless, the paper finds that when interest rates are low, banks not only increase the number of new risky loans but also reduce the rates they charge risky borrowers relative to those they charge less risky ones. Interestingly, the reduction in the corresponding spread — and the extra risk — is higher for banks with lower capital ratios and more bad loans.

Stock values point to recovery

Strong gains on Wall Street and in Asia have seen the top shares open 0.7 percent higher today, which along with a 21 percent rally in the FTSE index this quarter has given signs that the global recession could be making a stronger-than-anticipated recovery.

Domestic forecasts also point to economic recovery. Philip Shaw, chief economist at Investec, said “we expect growth to return in Q3”. This comes as retailers reported a picking up of spending in the month of July. As ever, this comes with a note of caution; the Bank of England warned that it was no quick fix, and the long-term may still require pro-active intervention to bolster recovery.

In news even closer to home, Gordon Brown has been talking about cuts. It seems a point of break-even is a while away, as the government needs to borrow £2 for every seven it spends. But where to make cuts? The UK’s swollen public sector needs to retreat, but a hatchet-job certainly won’t do the trick. Though whether allowing state borrowing to rise further is a viable course of action remains to be seen. Feeding into this comes the revelation that the UK’s jobless rate now stands at 7.9 percent, or a total of 1.61 million people. There is no quick silver lining to this multi-part problem.

Escaping may be the best option, at least for now-former Barclays bankers Stephen King and Michael Keeley, who are leaving to set up C12 Capital Management in the Cayman Islands. The firm are buying $12.3bn of Barclays’ debt, which will not be removed from the bank’s balance sheet but will be treated differently – Barclays will no longer need to price its assets at current market values. It’s an obtuse set up in a climate where transparency and clarity are being promoted as the values to pursue, a move that has astonished many.

In a parallel world, traders have been using StockTwits, a Twitter-based service, to track relevant discussions on stock trends. Traders tweet their opinions which are picked up and displayed on StockTwits’ own website, making the formerly mantled compartment of finance as transparent and public as can be. There are currently 90,000 people signed up to the site, of which about 15,000 tweet. It’s easy to watch how amateur day traders operate and notice trends from the outside, and may be a valuable template to follow in this pro freedom-of-information world we’re moving rapidly into.