Interest rate smoothing and financial stability

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.