Financial Stability Policies and Bank Lending

The aim of this research project is to answer a question that has been widely debated among policymakers and academic economists: Should increased systemic risk in the financial sector be addressed with conventional monetary policy that "leans against the wind" (i.e. sets a higher interest rate than would be warranted based on inflation or real economic considerations alone), or should it be countered with more targeted, so-called "prudential" measures (such as bank-specific capital requirements)? Existing studies on the effects of different financial stability policies are predominantly theoretical and yield conflicting conclusions. Economic trade-offs are one reason for the lack of consensus in the literature. On one hand, generalized interest rate increases cannot be as easily circumvented as targeted prudential measures because they affect everyone in a given monetary area. In contrast, prudential measures primarily focus on specific financial institutions deemed unsound, while leaving healthy ones unaffected. This allows room for regulatory arbitrage, reducing the effectiveness of targeted prudential measures in containing systemic risk. On the other hand, leaning against the wind could result in significant economic collateral damage as a higher interest rate usually depresses aggregate demand. Targeted prudential interventions are designed in a way to minimize precisely these negative consequences. Compelling empirical studies on the comparative effects and effectiveness of different financial stability policies face several challenges. Since the two described types of measures are often seen as alternatives, it is hardly possible to compare both while keeping the environment and time constant. Additionally, valid control groups are almost never available. Financial sectors subjected to financial stability policies (treatment group) exhibit increased systemic risk. Hence, they fundamentally differ from financial sectors that remain without economic policy interventions because they show no build-up of potentially dangerous risks (control group). The present research project aims to overcome these challenges by exploiting a research design rooted in economic history. It relies on regional monetary policy differences within the United States. Between 1914 and 1935, the twelve (still existing) Federal Reserve districts were able to pursue different monetary policies. In May 1920, four of these districts decided to increase their interest rates to counter a significant expansion of bank lending. Four other districts resorted to a prudential measure. The remaining four districts did not take any special action. Enabling a local comparison of detailed bank-level data in small bands around district boundaries, this historical episode thus provides unique conditions to identify the causal effects of different financial stability policies, while keeping environment and time fixed.

No additional funding sources recorded.