Monetary Policy, Bank Leverage, and Financial Stability

42 Pages Posted: 25 Oct 2011

See all articles by Fabián Valencia

Fabián Valencia

International Monetary Fund (IMF)

Multiple version iconThere are 3 versions of this paper

Date Written: October 25, 2011


This paper develops a model to assess how monetary policy rates affect bank risk-taking. In the model, a reduction in the risk-free rate increases lending profitability by reducing funding costs and increasing the surplus the monopolistic bank extracts from borrowers. Under limited liability, this increased profitability affects only upside returns, inducing the bank to take excessive leverage and hence risk. Excessive risk-taking increases as the interest rate decreases. At a broader level, the model illustrates how a benign macroeconomic environment can lead to excessive risk-taking, and thus it highlights a role for macroprudential regulation.

Keywords: Financial Stability, Bank Leverage, Risk-Taking, Monetary Policy, Macroprudential Regulation

JEL Classification: C61, E32, E44

Suggested Citation

Valencia, Fabian V., Monetary Policy, Bank Leverage, and Financial Stability (October 25, 2011). Available at SSRN: or

Fabian V. Valencia (Contact Author)

International Monetary Fund (IMF) ( email )

700 19th Street, N.W.
Washington, DC 20431
United States

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