Monetary Conditions and Bank Loan Risk Taking: Evidence From the North and South Wales Bank, 1881-1894

I investigate the effects of the monetary rate, the interest rate set by the Central Bank, on bank risk taking by examining a sample of loan contracts secured by shares and extended by the North and South Wales Bank between 1881 and 1894. Collateralization by shares allows me to construct a measure of ex ante risk taking for each loan: the collateral value to loan amount ratio. Exploiting the fact that Britain was on the Gold Standard at that period in time allows me to address possible endogeneity issues. I use the number of gold rushes in a year as an instrumental variable for the monetary rate, by arguing that an unexpected windfall in the gold supply serves as an exogenous shock to the money supply, translating to a cut in the monetary rate. Results are consistent with theories indicating that low Central Bank interest rates can induce bank loan risk taking in the search for yields, as I find that collateral value to loan ratios are lowered following a cut in the monetary rate. I also find that low monetary rates corresponded with, on average, lower loan prices.

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