INTRODUCTION

After the burst of the dotcom bubble, many central banks have adopted a low interest rate regime over an extended period to ward off recession. Persistently low real interest rates can fueled a boom in asset prices and securitized credit and lead financial institutions to take on increasing risk (Nicolo et al., 2010).

DOI: 10.4018∕978-1-4666-6268-1.ch027 hot issue and a focal point of the debate in both academic circle and practice circle, especially after the 2008 international financial crisis (Ma & Sun, 2010; Chang, 2010).

The theoretical research in the literature suggests several channels that monetary policy (mainly interest rate) affects bank risks. First, interest rate policy of the central bank affects the bank’s risks through asset valuation, business income, and cash flows, and the interest margin (Adrian & Shin, 2009; Borio & Zhu, 2008). Sec­ond, monetary policy affects bank risks through portfolio reallocation and risk transfer. As a result, the risk of the bank’s investment portfolio and asset pricing will be affected. More importantly, the effect of monetary policy changes on bank risks may not be uniform across time, banking systems, or individual banks (Nicolo et al., 2010).

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The empirical research shows some conflicting findings. First, loose monetary policy leads to an increase in bank risk and tight monetary policy can prevent the accumulation of bank risk (Angela & Peydro, 2010; Ioannidou et al., 2009; Delis & Kouretas, 2011; Yu & He, 2011),while others (Lucchetta, 2007; Tan & Su, 2011) indicate that loose monetary policy may reduce bank risks and tight monetary policy may increase bank risks.

In China, the objective of the monetary policy is to maintain the stability of the value of the cur­rency and thereby promote economic growth. To achieve the objective, China utilizes synthetically and extensively the administrative monetary policy instrument (mainly reserve requirement ratio) and market-oriented monetary policy instruments (mainly the interest rate and open market opera­tion). The time series ofreserve requirement ratio, interest rate and open market operation are reported in Table 1. During 1998-2011, the People’s Bank of China (China’s Central Bank) had raised or decreased the 1-year benchmark deposit rate for twenty-two times continually with fifteen times since 2007(six times in 2007,four times in 2008, two times in 2010 and three times in 2011). At the end of 2011, the 1-year benchmark deposit rate is 3.50 percent. RMB open market operation resumed trading on May 26, 1998, and expanded the scale gradually. In particular, since 2006, turnover of trading of T-Bond in total(spot trading and repo. trading included) had been lifted continually from 1063.35 billion Yuan in 2006 to 20084.133 billion Yuan in 2011(see Table 1). Because the interest rate is not fully market-oriented in China and the effects of the open market operations are partly constrained by weaker purchasing willing­ness on the part of commercial banks, the PBC increased the use of the reserve requirement ratio as a policy instrument. From 1998 to 2011, the People’s Bank of China had adjusted the reserve requirement ratio for thirty-nine times, which is rarely seen in the world and brought it from 8.0 percent in March 1998 to 21.0 percent for the large financial institutions and 17.5 percent for small and medium-sized financial institutions in December 2011.

Table 1. The time series of reserve requirement ratio, interest rate and open market operation

Note: The reserve requirement ratio is the ratio for the large financial institutions. The interest rate refers to the 1-year benchmark deposit rate.

reserve requirement ratio had been changed fre­quently for thirty-two times with ten times in2007, nine times in 2008, six times in 2010 and seven times in 2011.The above three instruments have played a significant role for managing liquidity, to facilitate efforts to normalize money and credit growth, and to handle inflationary expectations, which contributes to achieve the stable price level and economic growth.

As for China’s stability of banking industry, the financial system is bank-based in China and the Chinese commercial banks directly affect finan­cial stability of the whole economy. Though the financial stability is not included in the objective of China’s monetary policy, the People’s Bank of China attaches much importance to financial stability in practice and China’s banking industry is in good condition. Since July 2003, the People’s Bank of China has carried out the self-assessment on China’s financial stability and released China Financial Stability Report. In August 2009, China officially started the Financial Sector Assessment Program (FSAP), which was jointly launched by the IMF and World Bank in May 1999. On April 19, 2011, Dagong Global Credit Rating Co. Ltd. released the report-2011 Credit Risk Guidelinefor Chinese Banking Industry that gave a latest evalu­ation on the major banks’ credit risk in China and a “stable” prospect to the basic situations of the credit of China’s banking industry. On May 25, 2011, Standard & Poor’s said that China’s slower economic growth would likely cause the problem that Chinese banking industry experienced credit losses in the next 2 to 3 years. However, Standard & Poor’s maintained a “stable” rating on the prospects of China’s banking industry.

It seems that the above three monetary policy instruments have worked to make policies better- targeted and more flexible and a balance has been achieved between stable price level and stable banking industry in China. Hence, the financial stability implication of monetary policy actions should be thought much of. Are monetary policy actions helpful for bank stability in China? Is there a policy trade-off between price stability and fi­nancial stability, or can a single policy instrument achieve both at the same time in China? What should the relationship between monetary and regulatory authorities be? The key of the answers of the above questions is to explore how monetary policy affects banks’ risk in China.

Our study uses a panel data analysis to examine effects of the monetary policy on banks’ risk in China from 1998 to 2011. We differ from other studies in several ways. First, in the US and Euro­pean countries, interest rate is the major monetary policy instrument. Thus, they focus primarily the effect of interest rates on bank risks. The Chinese government has the flexibility of using three policy measures that are considered to be critically im­portant. In addition to the interest rate, the People Bank of China can utilize the reserve requirement ratio and open market operation effectively to monitor the Chinese economy. We investigate several policy instruments in our study: interest rate, reserve requirement ratio and open market operation. Second, we evaluate and compare the different effects of price-based monetary policy instrument through interest rate and the quantita­tive monetary policy instruments (mainly reserve requirement ratio) on bank risks. Our study thus provides meaningful policy guidance in implemen­tation in China. The results also provide useful information to policymakers in emerging markets in designing their monetary policy.

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