The Effect of Interest Rates on Bank Risk-Taking: Evidence from Banks in China

There is a belief among some economists that 2008 financial crisis was caused by continuous low interest rates environment. They argue that low interest rate environment from the early to mid-2000s lead to the increase of banks’ risk-taking appetite. Many empirical studies conducted in western countries have proven the negative relationship between interest rates and bank risk-taking. In this paper, we examine whether or not this connection exists within the Chinese economy. We measure bank risk-taking behaviour based on the ratio of non-performing loans to total loans, and we find its relationship with two different kinds of interest rates: legal and market interest rates. In addition, we divided control variables into internal and external variables. We analyzed more than 800 observations made on Chinese banks between 2003 and 2012. Consistent with similar studies conducted in western countries, we found that low level interest rates substantially increased bank risk-taking behaviour.