Procyclical Bank Risk-Taking and the Lender of Last Resort

We show that through facilitating maturity transformation, the lender of last resort gives banks an incentive to lever, diversify, and lower their lending standards. Bank leverage increases shareholder value because maturity transformation effectively allows banks to borrow against lower interest rates than their shareholders. Bank diversification increases shareholder value by enabling banks to lever more. When the gains from maturity transformation are passed on to bank customers, lending standards deteriorate. This risk-taking intensifies when the term spread is steeper, and is thus procyclically related to the stance of the macro-economy. Regulatory liquidity requirements can reduce all forms of risk-taking examined.

Keywords : bank risk-taking, procyclicality, lender of last resort, financial regulation.

JEL Codes: G01, G21, G28, G32.

Working paper no. 301