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. I propose and validate the loan-loss mechanism: 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 where 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.
- 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)