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Interest rates, capital and bank risk-taking

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  • Acosta-Smith, Jonathan

    () (Bank of England)

Abstract

Are low interest rates more likely to incentivise greater bank risk-taking? This is the question we seek to answer. Using a model in which banks raise funds from depositors to create an investment portfolio which can differ in its risk and return, we suggest so. In particular, we show that lowering the interest rate makes it more likely banks will make risky investments. This is because reducing the interest rate makes safer assets less attractive, while increasing the relative gains from gambling. We show that risk-taking is highly dependent on banks’ skin-in-the-game, as banks always ignore the full extent of losses on bankruptcy. Raising the interest rate has a similar effect. It reinforces this behaviour, as by increasing the yield on the portfolio, banks have more to lose on bankruptcy.

Suggested Citation

  • Acosta-Smith, Jonathan, 2018. "Interest rates, capital and bank risk-taking," Bank of England working papers 774, Bank of England.
  • Handle: RePEc:boe:boeewp:0774
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    References listed on IDEAS

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    More about this item

    Keywords

    Banking; monetary policy; risk-taking; interest rates;
    All these keywords.

    JEL classification:

    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
    • E58 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Central Banks and Their Policies
    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages

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