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Do Low Interest Rates Sow the Seeds of Financial Crises?

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Author Info

  • Simona E. Cociuba
  • Malik Shukayev
  • Alexander Ueberfeldt

Abstract

A view advanced in the aftermath of the late-2000s financial crisis is that lower than optimal interest rates lead to excessive risk taking by financial intermediaries. We evaluate this view in a quantitative dynamic model in which interest rate policy affects risk taking by changing the amount of safe bonds that intermediaries use as collateral in the repo market. In this model with properly-priced collateral, lower than optimal interest rates reduce risk taking. We also consider the possibility that intermediaries can augment their collateral by issuing assets whose risk is underestimated by credit rating agencies, as was observed prior to the crisis. In the presence of such mispriced collateral, lower than optimal interest rates contribute to excessive risk taking and amplify the severity of recessions.

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File URL: http://www.bankofcanada.ca/wp-content/uploads/2011/12/wp2011-31.pdf
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Bibliographic Info

Paper provided by Bank of Canada in its series Working Papers with number 11-31.

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Length: 56 pages
Date of creation: 2011
Date of revision:
Handle: RePEc:bca:bocawp:11-31

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Keywords: Transmission of monetary policy; Financial system regulation and policies;

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References

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  1. DellAriccia, Giovanni & Laeven, Luc & Marquez, Robert, 2011. "Monetary Policy, Leverage, and Bank Risk-taking," CEPR Discussion Papers 8199, C.E.P.R. Discussion Papers.
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Citations

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Cited by:
  1. Sami Alpanda & Gino Cateau & Césaire Meh, 2014. "A Policy Model to Analyze Macroprudential Regulations and Monetary Policy," Working Papers 14-6, Bank of Canada.
  2. Ekin Ayse Ozsuca & Elif Akbostanci, 2012. "An Empirical Analysis of the Risk Taking Channel of Monetary Policy in Turkey," ERC Working Papers 1208, ERC - Economic Research Center, Middle East Technical University, revised Dec 2012.
  3. Corbae, Dean & D'Erasmo, Pablo, 2014. "Capital requirements in a quantitative model of banking industry dynamics," Working Papers 14-13, Federal Reserve Bank of Philadelphia.

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