Short-term rates and banks' risk-taking (fg)

Recent financial turmoil gives rise to a number of questions. Perhaps you have already watched the interview with Peter Bernstein then you might recognized that the financial historian does not directly blame the financial models which are heavily used in portfolio management to be wrong. He rather notes that there are too many unkonwon unknowns in today's financial environment which cannot be traced down by any finanical model. I do aggree partly with this statement, though I am convinced that a broader look at things might have served as early indicators, especially for investment trusts etc.

Recent academic literature asks the question why is it that banks and investors took so much risk. There are many potential answers which might help to understand it.

• In times of low interest rates borrowers' net worth is higher thereby reducing the agency costs of lending and making banks more willing to lend to higher risk borrowers who have less collateral. Matsuyama (2007), “Credit Traps and Credit Cycles”,American Economic Review, 97.
• Low interest rates can also mitigate adverse selection which leads to an increase in risk-taking. G. Dell’Ariccia and R. Marquez (2006), “Lending Booms and Lending Standards”, Journal of Finance, 61.
• In times of high liquidity banks are less concerned about re-financing and thus, take more risks. Diamond and R. Rajan (2006) “Money in a Theory of Banking”, American Economic Review, 96.
• In times when short-term (riskless) interest rates are low banks have to incentive to take positions in risiker assets since the riskless assets do not yield enough return. R. Rajan, (2006), “Has Finance Made the World Riskier?”, European Financial Management, 12.
• When the short-rate approaches the banks' deposit rates, bank profits shrink and induce a further activity in risky assets.
• And, from the point of view of asset pricing models, Goodhart et al. (2007) showed that liquidity shocks affet the term premia of the yield curve. In times of high liquidity, many models based on a consumption-based asset pricing model underestimate risk premia.