Book Description

I study whether expansive monetary policy over an extended period under benign economic conditions induces banks to shift their asset portfolios toward more risky investments. This may contribute to aggregate financial instability. Moreover, I investigate whether such a portfolio adjustment is also likely to be highly correlated among financial institutions. The second phenomenon not only leads to more individual risk but also contributes to systemic risk. I believe these are relevant policy questions for at least two reasons: First, the financial crisis of 2007-08 had a devastating impact on the world economy. Thus, it is important to investigate the role that monetary policy played for the extreme buildup of aggregate risk throughout the mid 2000s. I find that the period of expansive ECB monetary policy in the period 2003-2005 induced banks to significantly increase the default risk allowed in their loan portfolios. Second, policy interest rates across the world are currently very low. My theoretic and empirical research suggests that a significant improvement in economic conditions together with expansive monetary policy could spur another round of excessive risk buildup in financial institutions' asset portfolios. Furthermore, one of the greatest concerns during the financial crisis of 2007-08 was systemic risk within the financial sector. Thus, I ask whether financial institutions intentionally choose portfolios that are highly correlated with their competitors. Based on an extensive matched firm-bank panel I construct multiple time varying measures of bank herding within the Austrian business loan market during 2000-08. I show that bank herding in business lending markets was sizable and significant throughout the period 2000-08. Moreover, banks' tendency to herd into default-risk classes was especially pronounced during the low policy interest rate period 2003-05. This suggests that not only do low and stable monetary policy interest rates encourage more bank risk-taking, but the additional risk is also likely to be correlated across banks.