Rock-bottom interest rates are luring banks into taking risky bets and central banks should be alert to the negative effects of loose monetary policy on financial stability, a high-profile study showed.
The study from the Bank for International Settlements (BIS) found evidence of a significant link between an extended period of low interest rates prior to the financial crisis and banks' risk-taking.
The main implication of these findings is that monetary policy is not fully neutral from a financial stability perspective, the research paper, published in the BIS quarterly report, said.
It is important...that prudential authorities be especially vigilant during periods of unusually low interest rates, particularly if they are accompanied by other signs of risk-taking, such as rapid credit and asset price increases.
Banks' heavy betting on high-yielding exotic financial products have been widely blamed as one of the main reasons behind the spiraling financial crisis, which has lead to bank collapses and government bailouts worldwide.
Major central banks reacted by slashing interest rates to record lows to fight a deep economic recession.
European Central Bank Executive Board member Lorenzo Bini Smaghi and Swiss central banker Thomas Jordan have already warned against potentially distorting effects from ultra-low rates and against the risks to financial stability.
The BIS study said that low returns on investments such as government bonds may prompt financial players to take on more risk, for example to meet nominal target returns.
In addition low interest rates affect valuations, incomes and cash flows, which in turn can modify how lenders measure risks, the study said.
A reduction in key interest rates boosts asset and collateral values, which in turn can modify banks' estimates of probabilities of default and volatility, the study said.
For the full BIS report click:
(Reporting by Sven Egenter; Editing by Ron Askew)