BIS study quantifies monetary policy's impact on bank risk-taking
A new Bank for International Settlements working paper demonstrates how monetary policy influences bank credit policy through the risk-taking channel. It finds that a decline in bank equity tail risk after Federal Open Market Committee (FOMC) announcements leads banks to lend more to riskier firms and ease loan terms.
Quantifying the Fed put's impact
The paper addresses identification challenges by combining bank equity put option returns on scheduled Federal Open Market Committee (FOMC) announcement days with a high-frequency research design.
It utilizes time-stamped loan-level commercial and industrial (C&I) data from the Y-14Q, the US credit register for large loans.
This empirical setting allows researchers to extract the impact of FOMC announcements on market beliefs about future bank equity returns and study the consequences for banks' credit policy, while holding credit demand fixed.
A key finding is that a decrease in a bank's tail risk following an FOMC announcement is associated with increased risk-taking in its loan book.
A one percentage point decline in tail risk correlates with a 1.6 percent decrease in originating the safest loans and a 1.5 percent increase in originating loans with the highest probability of default.
These effects are concentrated in the bottom quartile of the tail risk distribution.
The 'Fed put' and risk-taking
The study builds on the concept of the risk-taking channel of monetary policy.
Expansionary policy or central bank communication that reduces perceived downside risks to banks' near-term equity values is often referred to as the 'Fed put.'
This perceived monetary policy 'insurance' can induce banks to loosen credit standards and lend to riskier firms.
The risk-taking channel is also mediated by a bank's competitive environment and internal agency frictions.
For instance, in competitive loan markets, high-powered incentive contracts, like cash bonuses, may encourage loan officers to approve higher-risk loans when monetary policy offers downside protection to bank equity.
Unveiling hidden policy levers
The study credibly quantifies the risk-taking channel, a complex aspect of monetary policy often difficult to measure.
It highlights how institutional frictions and competitive dynamics significantly mediate policy transmission.
For central banks, this reveals a nuanced mechanism through which their actions can inadvertently influence bank risk-taking.