Collateralized Borrowing and Risk Taking

A view advanced in the aftermath of the late-2000s …nancial crisis is that lower than optimal interest rates lead to excessive risk taking by …nancial intermediaries. We evaluate this view in a quantitative dynamic model where interest rate policy aects risk taking through two channels. First, policy in‡uences the attractiveness of safe bond investments relative to riskier assets. Moreover, policy changes the amount of safe bonds available for collateralized borrowing in interbank markets. In this framework, collateral constraints provide a safeguard against increases in risk taking. Lower than optimal policy rates lead to tighter collateral constraints and reduce risk taking.