Interest Rate Smoothing and Financial Stability

32 Pages Posted: 12 Aug 2004

See all articles by R. Todd Smith

R. Todd Smith

University of Alberta

Henry van Egteren

University of Alberta - Department of Economics

Date Written: July 2004

Abstract

Central banks smooth fluctuations in interest rates based on a belief that this policy promotes financial stability. This belief is based on a presumption that the direct effect of less interest rate volatility on a bank's likelihood of insolvency is the predominant effect of this policy. The main point of this paper is that these policies also give rise to indirect effects that lower financial stability. These indirect effects occur because the policy itself alters bank behavior. In effect, if the central bank provides (liquidity) insurance (at zero premia), it may introduce a classic moral hazard problem that encourages risk-taking by banks. As a result, to maintain a given degree of financial stability, a bank regulator may, in fact, need to impose a higher prudential capital requirement when an interest rate smoothing policy is in place. The paper concludes that the link between interest rate smoothing policy and financial stability may be more complicated than is generally recognized.

Keywords: Banks, interest-rate smoothing, central banking, bank regulation

JEL Classification: G18, G28, E58

Suggested Citation

Smith, Richard Todd and van Egteren, Henry, Interest Rate Smoothing and Financial Stability (July 2004). Available at SSRN: https://ssrn.com/abstract=575221 or http://dx.doi.org/10.2139/ssrn.575221

Richard Todd Smith (Contact Author)

University of Alberta ( email )

8-14 Tory Building
Edmonton, Alberta T6G 2H4
Canada
403-492-7898 (Phone)
403-492-3300 (Fax)

Henry Van Egteren

University of Alberta - Department of Economics ( email )

Edmonton, Alberta T6G 2H4
Canada
780-492-7637 (Phone)

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