A funding liquidity risk channel for monetary policy transmission

Abstract

We study the borrowing of a bank subject to rollover risk and derive implications for monetary policy transmission and financial stability. The optimal borrowing balances the benefit of additional profitable investments with the cost of higher bank fragility. This trade-off leads to a funding liquidity risk channel for monetary policy transmission. While a tighter policy decreases borrowing, its effect on financial stability depends on the interaction between a price effect and an opposing scale effect. In particular, the price effect dominates whenever the risk-free rate is low, impairing financial stability. Thus, an exit from a low-interest rate environment may increase bank fragility. We derive several testable implications for monetary transmission and bank fragility.

Keywords: rollover risk, monetary policy, fragility, global games, funding liquidity risk channel.

JEL Classification: G01, G21, G28