The Tipping Point: Interest Rates and Financial Stability

Abstract This paper studies the impact of interest rates on bank stability in a standard bank‐run model. Banks invest in long‐term assets, whose value decreases with interest rates, and set deposit rates to optimally insure depositors' liquidity risk. Liquidity‐risk insurance implies banks earn interest margins, which increase with interest rates. Hence, interest rates have two countervailing effects: they reduce the value of banks' long‐term assets while widening their margins. First, the paper characterizes the parametric condition under which an effect dominates. The condition implies interest‐rate risk is captured by banks' maturity mismatch adjusted for deposits' effective duration. Second, the paper solves for the interest‐rate level that tips banks into instability. Quantification points to the possibility of a negative effective maturity mismatch, making the tipping point a lower bound on interest rates.