How do interest rate levels affect credit loss rates? A rule of thumb approach
Summary
Focus
We examine how increases in central bank policy rates translate into realised bank credit losses across 113 advanced and emerging market economies over 1990–2022. It estimates the average elasticity of loss rates to rate hikes and studies when this effect is stronger or weaker, conditioning on the business cycle, inflation, private debt, the pre-tightening monetary stance, fiscal stance, and central bank balance-sheet policies. It also considers structural features that shape pass-through – such as the prevalence of floating-rate lending, exchange-rate dynamics and FX interventions – and validates country-level results with bank-level evidence from 3,350 institutions.
Contribution
The study delivers global, policy-ready 'rules of thumb' linking a 1 percentage point policy-rate change to expected changes in credit loss rates over a three-to-five-year horizon. It is among the first to quantify state dependence for realised loan losses (rather than market-based risk metrics) across countries and at bank level, and to show how lending structures and pre-existing asset quality shape outcomes. The estimates are set up for direct use in stress-testing and macroprudential calibration, clarifying when monetary tightening poses greater financial-stability risks and when complementary fiscal or balance-sheet policies can mitigate them.
Findings
On average, a 1 percentage point policy-rate increase raises loan loss rates by about 0.1 percentage points over a three-to-five-year horizon, with much larger effects when policy had been loose, private debt and inflation are high, the economy is in a downturn, fiscal policy is restrictive, central bank balance sheets are shrinking, and floating-rate loans are prevalent. Banks with weaker pre-tightening asset quality see the largest increases, implying that monetary, prudential and stress-testing frameworks should factor in these credit-risk elasticities to safeguard financial stability.
Abstract
This paper investigates how changes in monetary policy interest rates affect credit loss rates in advanced and emerging market economies using annual data for 113 countries over the past three decades. Applying local projections, we find that a 1 percentage point increase in policy rates raises loan loss rates, on average, by 0.1 percentage points - an economically significant effect that is larger in relative terms in advanced economies than in emerging market economies. These rule-of-thumb estimates are robust across methodologies, including instrumental-variable estimation, exogenous monetary policy shocks, and bank-level data. Crucially, the effect of rate hikes is strongly state dependent: it intensifies when pre-tightening monetary policy is loose, private debt is high, fiscal policy is contractionary, the economy is in a downturn, and central bank balance sheets are shrinking at the same time. Banks with riskier pre-tightening loan portfolios record larger increases in credit losses. Our findings suggest that central banks and prudential authorities should account for the side effects of monetary policy and incorporate credit-risk dynamics into macroprudential and stress-testing frameworks to safeguard financial stability.
JEL classification: E32, E52, G21, G28, G32
Keywords: credit loss rates, interest rates, monetary policy, financial stability, macro-financial conditions
