ECB Monetary Policy and the Term Structure of Bank Default Risk

Euro Area banks have been confronted with unprecedented monetary policy actions by the ECB. Monetary policy may affect bank risk profiles, but the consequences may differ for short-term risk versus long-term or structural bank risk. We empirically investigate the association between the ECB’s monetary policy stance and market-perceived shortterm and long-term bank risk, using the term structure of default risk captured by bank CDS spreads. The results demonstrate that, during the period 2009-2020, ECB expansionary monetary policy diminished bank default risk in the short term. However, we do not observe a similar decline in long-term bank default risk, since we document that monetary stimulus is associated with a steepening of the bank default risk curve. The reduction of bank default risk is most pronounced during the sovereign debt crisis and for periphery Euro Area banks. From 2018 onwards, monetary policy accommodation is associated with increased bank default risk, both short term and structurally, which is consistent with the risk-taking hypothesis under which banks engage in excessive risk-taking behavior in their loan and securities portfolios to compensate profitability pressure caused by persistently low rates. The increase in perceived default risk is especially visible for banks with a high reliance on deposit funding.