Evidence abounds that in the decade leading up to the 2008 financial crisis, banks significantly expanded their loan portfolios, often by extending loans to risky customers, and financing themselves primarily with debt. This led to a rash of bank failures as banks' loans failed to repay.

A new University of California, Davis, study says that the low interest rate environment that prevailed throughout most of that period was likely an important determinant of that risky behavior.

“It wasn’t until after the crisis that people, including policymakers as well as academic economists, started realizing that the level of interest rates may induce particular bank behavior,” said Robert S. Marquez, a professor at the UC Davis Graduate School of Management. “Prior to the crisis, few expected that low interest rates for extended periods were problematic and could have led to bank failures as there was very little, if any, guidance on this issue.”

The paper, soon to be published in the Journal of Economic Theory, establishes a link between interest rates and the risk-taking decisions by banks. In particular, the paper shows that reductions in real interest rates, such as occur as part of a monetary expansion, lead banks to increase their leverage and expand their loan portfolio.

In addition, the expansion in lending is primarily to borrowers who are less likely to repay their loans in full. This makes the bank itself riskier and more prone to failure.

He said strict enforcement of strong equity-to-debt ratios could help forestall a crash in a weak economy being stimulated by monetary policy, but it might be unnecessarily restrictive in a good economy where capital forbearance would help solvent banks remain afloat.

“To the extent, however, that low interest rate periods may sow the seeds of future crises, care needs to be taken in balancing the two objectives of price and financial stability,” he said.

Marquez and co-authors plan future research into how monetary policy might prevent excessive risk-taking that could have led to some bank failures.

The paper, “Real interest rates, leverage, and bank risk-taking” is available online at ScienceDirect website.

Besides Marquez, co-authors are Giovanni Dell’Ariccia and Luc Laeven, both of the International Monetary Fund in Washington, D.C., and the Center for Economic Policy Research.

About the UC Davis Graduate School of Management

Dedicated to preparing innovative leaders for global impact, the UC Davis Graduate School of Management is consistently ranked among the premier business schools in the United States and internationally. The school’s faculty members are globally renowned for their teaching excellence and pioneering research in advancing management thinking and best practices. With prime locations in Northern California’s economic hubs, the school provides a bold, innovative approach to management education to more than 550 full-time MBA students and Master of Professional Accountancy students at the UC Davis campus, and part-time MBA students in Sacramento and the San Francisco Bay Area.