Financial Stability and Regulatory Policy in a Low Interest Rate Environment Financial Stability and Regulatory Policy in a Low Interest Rate Environment

Prepared for the next crisis? The costs and benefits of financial regulation

Norges Bank and International Banking, Economics and Finance Association

  1. Takeaway: It is important at this stage of the business cycle to assess whether our economies are prepared for a hypothetical next downturn, and consider whether policymakers have built sufficient resilience into the financial system.

    Excerpt: One significant difference between now and previous cycles is the low level of interest rates in the United States, Germany, and Japan. […]  The low interest rate environment that many developed countries face requires policymakers to re-examine other economic buffers.”
  2. Takeaway: One effect of the low interest rate environment is that monetary policy buffers are diminished. For instance, in the event of a hypothetical downturn, policymakers have little room to try to stimulate the economy by reducing short-term rates.

    Excerpt: “Given the current diminished monetary policy buffer, recessions may be deeper and recoveries slower than what we have experienced historically, unless additional buffers are provided by fiscal, regulatory, and financial stability policies and deemed appropriate to utilize by policymakers.”
  3. Takeaway: The diminished capacity of monetary policy to offset shocks implies policymakers also need to carefully examine regulatory and financial stability tools. But the policies and tools that may have been appropriate during a downturn in a high interest rate environment are not likely to be sufficient in a low interest rate environment.

    Excerpt: “For several reasons, a low interest rate environment makes it more difficult to exit recessions. This difficulty is due not just to the smaller monetary policy buffer, but also to the fact that a low interest rate environment encourages greater household and firm leverage that will amplify the severity of a downturn, should it occur.”
  4. Takeaway: Steps that increase capital would put banks in a better position to handle an economic downturn, and hopefully, better-capitalized banks would help compensate for limited monetary and fiscal policy buffers.

    Excerpt: “I am not sure that recent developments and proposals in bank regulation properly reflect the risks we are likely to face in a low interest rate environment that challenges bank profitability and provides less by way of monetary policy buffers. Specifically, capital buffers should be rising now so that there is more room for them to decline if the economy falters. While this is true for the United States, it may be even more true in Japan and Europe.”
  5. Takeaway: In a low interest rate environment, corporations and households have more incentive to add debt. Meanwhile, a greater global willingness to pursue higher yields creates a ready market for highly leveraged loans. This excessive leverage could amplify the economic problems that arise in a downturn.

    Excerpt: “I believe U.S. policymakers would do well to explore ways that policies could be used to prevent the buildup of leverage in a low-rate environment, hopefully reducing the macroeconomic spillover that could result from over-levered households and firms.”

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