The Low Monetary Rates Paradox, Banking Stability and Credit: Evidence from the Euro Area

Abstract

Low monetary policy rates may induce risk-taking by banks, increasing the probability that a banking crisis occurs. Once the crisis starts, central banks may lower rates to support the weak banking system to avoid a credit crunch, in turn sowing the seeds for the next credit bubble. We provide evidence on this paradox of low monetary policy rates in the Euro area, where the unique dataset of the Euro area Bank Lending Standards and the institutional setting for monetary policy and prudential policy allow econometric identification. We find robust evidence that low monetary policy interest rates soften lending standards (the part of lending conditions unrelated to borrowers’ risk) in the period prior to the crisis. Moreover, the impact of low short-term rates on credit and liquidity risk-taking is statistically and economically more significant than the effect of low long-term interest rates or current account deficits. Furthermore, the impact of low monetary policy rates on the softening of standards is reduced by more stringent prudential policy on either bank capital or LTVs. After the start of the 2008 crisis, we find that low monetary policy interest rates soften tightened lending conditions and terms that were present due to bank capital and liquidity constraints, especially for banks that borrow more long-term liquidity from the Eurosystem.