Interest Rates, Market Power, and Financial Stability

This paper analyzes the effects of policy rates on financial intermediaries' risk-taking decisions. We consider an economy where (i) intermediaries have market power in granting loans, (ii) intermediaries monitor borrowers which lowers their probability of default, and (iii) monitoring is not observable which creates a moral hazard problem. We show that lower policy rates lead to lower intermediation margins and higher risk-taking when intermediaries have low market power, but the result reverses for high market power. We also show that when intermediaries have high market power competition from (non-monitoring) financial markets results in a U-shaped relationship between policy rates and risk-taking. The paper examines the robustness of these results to introducing heterogeneity in monitoring costs, entry and exit of intermediaries, and funding with deposits and capital.