Side effects of monetary easing in a low interest rate environment: reversal and risk-taking

Since 2014, the European Central Bank (ECB) and other central banks have been pursuing a negative interest rate policy (NIRP).

Metadata

Provider:

ECB

URL:

https://www.ecb.europa.eu//pub/economic-research/resbull/2021/html/ecb.rb210921_1~990bfeaab7.en.html

Retrieved on:

Friday, November 11, 2022

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Summary

Key Points:

Since 2014, the European Central Bank (ECB) and other central banks have been pursuing a negative interest rate policy (NIRP).
The controversy about monetary policy in a low rate environment hinges on the existence of a zero-lower bound (ZLB) on interest rates (Coibion et al., 2012).
In a low or negative interest rate environment, it becomes harder for banks to pass on the reduction in the policy rate to their depositors.
This means a policy rate cut translates into a lower interest rate margin and reduces the net worth of banks.
In our recent paper (Heider and Leonello, 2021), we present a simple conceptual framework to show how a policy rate cut affects both bank lending and risk-taking in a low or negative interest rate environment versus a high interest rate environment.
The substitutability between loans, deposits and bonds is the channel through which the policy rate affects loan and deposit rates.
Reversal occurs when a cut in the monetary policy rate reduces lending instead of increasing it (Brunnermeier and Koby, 2018).
The level of the policy rate at which lending is maximal identifies the reversal rate.
Reversal is related to but not directly triggered by reduced profits from a contraction in the net interest margin at the ZLB.
This implies that when the policy rate falls below the reversal rate, a policy rate cut leads to increased risk-taking.
With market power, an increase in the lending volume reduces the loan rate, which then further reduces the benefit from screening.
Our research suggests that there are potential side effects of monetary stimulus in a low interest rate environment: reduced lending and increased risk-taking by banks.