Do Higher Interest Rates Make The Banking System Safer? Evidence From Bank Leverage

Abstract

A vast theoretical literature claims that increasing interest rates reduces bank leverage, therefore making banks safer. The empirical validity of this claim is critical to improving our understanding of the transmission of monetary policy through banks in addition to informing the ongoing debate on whether monetary policy should be used to support financial stability. I show empirically that raising interest rates actually increases bank leverage. I propose and empirically validate a mechanism that explains the overall increase in bank leverage in response to monetary policy shocks which I term the loan-loss mechanism: contractionary shocks increase loan losses, reduce bank profits and equity, and ultimately increase bank leverage. I document why much of the theoretical literature is unable to explain the leverage response and develop a banking model where floating-rate loans entail a trade-off between interest rate risk and credit risk, which generates the loan-loss mechanism. Using microdata, I provide empirical evidence consistent with floating-rate loans hedging interest rate risk at the expense of generating loan losses.

Prizes:
- Young Economist Prize (Runner-Up)
- Southern Economic Association Graduate Student Prize
- Rady School of Management Libby Award
- Walter Heller Memorial Prize (Best 3rd Year Paper)

External Seminars and Conferences:
- Southern Economic Association Annual Conference (2023)
- Federal Reserve Board Monetary Affairs Seminar (2023)
- King’s College London QCGBF Annual Conference (2023)
- Midwest Macroeconomic Conference (2023)
- London Business School TADC (accepted)