Interpac Business and Migration Solutions Melbourne Australia

December 7, 2009

THE ultra-low level of global interest rates may increase the risk of excessive risk-taking by banks, and consequently of new asset price bubbles, said a study published today by the Bank for International Settlements.

A special report in the BIS's quarterly survey of international finance concluded that there is "evidence of a significant link between an extended period of low interest rates prior to the (2007-2008 financial) crisis and banks' risk-taking".

The BIS's report comes against the background of a degree of unease at the strong performance of financial markets this year, which some senior European Central Bank officials have said are out of kilter with economic fundamentals.

It also adds further fuel to the debate about whether central banks should use interest rates or other policy measures to deflate asset price bubbles, as opposed to the laisser-faire doctrine that prevailed before the financial crisis.

The report's author Leonardo Gambacorta urged central banks to "learn how to factor in the effect of their policies on risk-taking", adding that "monetary policy is not fully neutral from a financial stability perspective".

The argument is all the more interesting since many of Europe's top central bankers are due to assume a co-responsibility for system-wide financial stability, a dual role that some argue contains an inherent conflict of interest.

"It is important...that prudential authorities be especially vigilant during periods of unusually low interest rates, particularly if they are accompanied by other signs of risk-taking, such as rapid credit and asset price increases," Mr Gambacorta concluded.

Although asset prices have performed strongly this year, credit aggregates have not. The BIS report also said overall international banks shrunk their balance sheets by $US477 billion ($521bn) in the second quarter, due almost entirely to a drop in interbank lending in the period. International loans to companies were up by $US4bn from the first quarter.

Overnight interest rates, which largely dictate broader conditions in money markets, have been well below 1 per cent for most of this year for US dollars, euros, yen and sterling.

That has allowed banks to make easy "carry" trades on government bonds that pay higher rates of interest. Yields on two-year German government bonds, for example, are now below the inflation rate that the ECB expects in the euro zone over that timeframe.

The BIS noted various signs of a return to health in global financial markets, notably in the issuance of debt securities by borrowers in emerging markets in the third quarter, for whom the market had been effectively closed since the collapse of US investment bank Lehman Brothers in the fall of 2008.

Emerging market borrowers issued $US34bn of new bonds in the quarter, up 52 per cent from the previous quarter and well above the quarterly average in the quarters leading up to the financial crisis.

(Source from The Australian)