We are grateful to Philipp Hartmann and Frank Smets for helpful comments. We thank Marco lo Duca for excellent research assistance. Ongena acknowledges the hospitality of the European Central Bank. Any views expressed are only those of the authors and should not be attributed to the Bank of Spain, the European We investigate the impact of the stance and path of monetary policy on the level of credit risk of individual bank loans and on lending standards. We employ the Credit Register of the Bank of Spain that contains detailed monthly information on virtually all loans granted by all credit institutions operating in Spain during the last twenty-two years – generating almost twenty-three million bank loan records in total. Spanish monetary conditions were exogenously determined during the entire sample period. Using a variety of duration models we find that lower short-term interest rates prior to loan origination result in banks granting more risky new loans. Banks also soften their lending standards – they lend more to borrowers with a bad credit history and with high uncertainty. Lower interest rates, by contrast, reduce the credit risk of outstanding loans. Loan credit risk is maximized when both interest rates are very low prior to loan origination and interest

We provide a theoretical foundation for the claim that prolonged periods of easy monetary conditions increase bank risk taking. The net e¤ect of a monetary policy change on bank monitoring (an inverse measure of risk taking) depends on the balance of three forces: interest rate pass-through, risk shifting, and leverage. When banks can adjust their capital structures, a monetary easing leads to greater leverage and lower monitoring. However, if a bank’s capital structure is …xed, the balance depends on the degree of bank capitalization: when facing a policy rate cut, well capitalized banks decrease monitoring, while highly levered banks increase it. Further, the balance of these e¤ects depends on the structure and contestability of the banking industry, and is therefore likely to vary across countries and over time. The views expressed in this paper are those of the authors and do not necessarily represent those of the IMF.

The efficacy of monetary policy depends largely on how it affects bank behavior. Recent events have cast doubt on how well monetary policy works in this respect, particularly during financial crises. In addition, issues have been raised about the role of banks in creating asset bubbles that burst and lead to crises. In this paper, we address these issues by focusing on bank liquidity creation, which is a comprehensive measure of bank output that accounts for all on- and off-balance sheet activities. Specifically we formulate and test hypotheses that address the following questions: (1) How does monetary policy affect total bank liquidity creation and its two main components, on- and off-balance sheet liquidity creation, during normal times? (2) Does monetary policy affect bank liquidity creation differently during financial crises versus normal times? (3) Is high aggregate bank liquidity creation an indicator of an impending financial crisis? We identify five financial crises and use data on virtually all U.S. banks between 1984:Q1 to 2008:Q4. Our main findings are as follows. First, during normal times, monetary policy tightening is associated with a reduction in liquidity creation by small banks, with much of the impact driven by a reduction in on-balance sheet liquidity creation. Monetary policy does not significantly affect liquidity creation by large and medium banks, which create roughly 90 % of aggregate bank liquidity.

A view advanced in the aftermath of the late-2000s …nancial crisis is that lower than optimal interest rates lead to excessive risk taking by …nancial intermediaries. We evaluate this view in a quantitative dynamic model in which interest rate policy a¤ects risk taking by changing the amount of safe bonds that intermediaries use as collateral in the repo market. In this model with properly priced collateral, lower than optimal interest rates reduce risk taking. We also consider the possibility that intermediaries can augment their collateral by issuing assets whose risk is underestimated by credit rating agencies, as was observed prior to the crisis. In the presence of such mispriced collateral, lower than optimal interest rates contribute to excessive risk taking and amplify the severity of recessions.

This paper presents a theoretical model of bank credit standards. It examines how a monopoly bank sets its monitoring intensity in order to manage credit risk when it makes long duration loans to borrowers who have private knowledge of their project’s stochastic profitability. The model has a recursive structure and contains heterogeneous agents who can selfselect to be depositors or borrowers at any point in time. The bank loan contract considered specifies the interest rate, the monitoring intensity and a profitability covenant. Within this class of contract, he bank chooses the terms which maximise Markov stationary profits subject to the constraint that it must have as many deposits as loans. As an illustrative example, the model is used to consider whether the reduction in credit standards and credit spreads observed before the financial crisis could have been caused by low official interest rates or a positive deposit shock. The model rejects a risk-taking channel of monetary policy and endorses the savings glut hypothesis. 1.

This paper on the relationship and effect of Credit and Liquidity Risk and on Bank Default Risk among Deposit Money Banks in Nigeria is aimed at assessing the extent to which the relationship between credit risk and liquidity risk influence the probability of bank defaults among deposit money banks, a study of First bank of Nigeria Plc. The study adopted experimental research design where questionnaires were administered to a sample size of eighty (80) respondents. The data obtained were presented in tables and analyzed using simple percentages. The formulated hypotheses were tested using the Pearson product moment correlation and chi-square statistical tool. The results of the study revealed that there is a positive relationship between liquidity risk and credit risk. This is based on the fact that an increase in credit risk (bad loan), the loan (asset) portfolio of such a bank is negatively affected causing an increase in bank illiquidity. Also, liquidity risk and credit risk jointly contribute to bank default risk. Based on the findings, it was recommended that internal loan and credit monitoring strategies should be implemented in full to ensure that loans and credit granted to customers are collected in full plus interest thereon and deposit money banks should not maintain excess liquidity simply because they want to effectively manage their liquidity position. 1.

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We study an economy where the lack of a simultaneous double coincidence of wants creates the need for liquidity. We show that the private provision of liquidity is inefficient: the private sector invests too much in collateralizeable assets and too much in relatively safe assets. The reason is that liquidity affects prices and the welfare of others, and creators do not internalize this. The government can eliminate the inefficiency by restricting the creation of liquidity by the private sector.

We study an economy where the lack of a simultaneous double coincidence of wants creates the need for liquidity. We show that the private provision of liquidity is inefficient: the private sector invests too much in collateralizeable assets and too much in relatively safe assets. The reason is that liquidity affects prices and the welfare of others, and creators do not internalize this. The government can eliminate the inefficiency by restricting the creation of liquidity by the private sector.

In the past two decades, academic research has produced a massive amount of evidence highlighting the beneficial role of financial development for growth and for the allocation of investment. Yet, our current vision is dominated by instances of dysfunctional behavior of financial markets associated with acute and widespread crises. This begs the issue of when and why finance stops being the “lifeblood ” and turns into a “toxin ” for real economic activity. This paper is a tentative first step in this direction. It highlights that this metamorphosis appears to occur when finance becomes “too large” relative to the underlying economy: it then stops contributing to economic growth and starts threatening the solvency of banks and systemic stability. A related question is why regulation is not designed so as to prevent the financial industry from growing above this threshold. I argue that a large part of the answer lies in the symbiosis between politicians and the finance industry.