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

Abstract

A vast theoretical literature claims that increasing interest rates reduce bank leverage, making banks safer. Validating this empirically is key to understanding monetary policy transmission and its impact on financial stability. I show that raising interest rates increases bank leverage. This rise in leverage is consequential as it is accompanied by a meaningful increase in bank failure rates. I propose and validate the loan-loss mechanism which explains the entire increase in leverage: contractionary shocks increase loan losses, reduce profits and equity, thus raising leverage. I document why existing models cannot account for this and develop a model of bank risk transformation in which floating-rate loans convert interest rate risk to credit risk, leading to loan losses. Empirical evidence from microdata is consistent with the model’s predictions.

Prizes: IFABS Oxford Best Paper Award, 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)

Recent and Upcoming Presentations: SED Annual Meeting, Annual IJCB Research Conference, FIRS, IFABS Oxford, BIS-CEPR-Gerzensee-SFI Conference on Financial Intermediation, London Juniors Finance Workshop, Bank of Finland and CEPR Joint Conference on Monetary Policy