Policy interest rate, loan portfolio management and bank liquidity

• We analyze a bank loan portfolio decision by a bottom up computational approach.
• Low levels of the policy interest rate (r) lead banks to choose high risk borrowers.
• A reduction of r increases the volatility of the bank cash influx.
• The loan portfolio risk increases soon after an increase of r.
• A reduction of the lending time horizon increases cash influx volatility clustering.

This paper analyzes how the movements of the policy interest rate affect bank-relevant variables through changes in the composition of the loan portfolio. Using a computational approach that fully accounts for borrowers’ heterogeneity, we show how the variety of bank customers changes and how this change affects the bank's cash influx, making it more volatile. The paper also sheds light on how the composition of the loan portfolio is affected by an increase in the policy interest rate when it is kept at low levels. Safer borrowers exit the loan portfolio first, causing a gradual increase in the loan portfolio risk. The interest payment influx shrinks because riskier borrowers repay less often. Furthermore, we find that a shortening of the lending time horizon increases the volatility clustering of the bank interest payment influx.