How do interest rate levels affect credit loss rates? A rule of thumb approach

This paper investigates how changes in monetary policy interest rates affect credit loss rates in advanced and emerging market economies using annual data for 113 countries over the past three decades. Applying local projections, we find that a 1 percentage point increase in policy rates raises loan loss rates, on average, by 0.1 percentage points - an economically significant effect that is larger in relative terms in advanced economies than in emerging market economies. These rule-of-thumb estimates are robust across methodologies, including instrumental-variable estimation, exogenous monetary policy shocks, and bank-level data. Crucially, the effect of rate hikes is strongly state dependent: it intensifies when pre-tightening monetary policy is loose, private debt is high, fiscal policy is contractionary, the economy is in a downturn, and central bank balance sheets are shrinking at the same time. Banks with riskier pre-tightening loan portfolios record larger increases in credit losses. Our findings suggest that central banks and prudential authorities should account for the side effects of monetary policy and incorporate credit-risk dynamics into macroprudential and stress-testing frameworks to safeguard financial stability.