Working Paper

Does Risk-Taking Increase or Decrease with Higher Interest Rates?

Abstract: We present a framework that accounts for how interest rates affect risk-taking by borrowers indirectly, by changing the borrower’s demand for credit (investment size). We find that this borrowing demand effect runs counter to the direct borrowing rate effect, and risk-taking can increase or decrease with higher rates depending on the relative strength of these effects. We show that the borrowing rate effect dominates when the borrower’s share of project returns is increasing in investment, so risk-taking increases with interest rates. However, the borrowing demand effect dominates when the borrower’s share of project returns is declining with investment demand, so that risk-taking decreases with higher interest rates. These results contribute to the understanding of linkages between monetary policy and financial stability. We apply our findings to study how lender competition affects risk-taking.

Keywords: borrowing; Risk-shifting; monetary policy; financial stability; lenders;

JEL Classification: D82; E52; G21; L13;

https://doi.org/10.18651/RWP2024-07

Bibliographic Information

Provider: Federal Reserve Bank of Kansas City

Part of Series: Research Working Paper

Publication Date: 2024-08-06

Number: RWP 24-07