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Monetary Policy, Bank Leverage, and Financial Stability

Fabián Valencia

International Monetary Fund (IMF) ; Princeton University

October 2011

IMF Working Paper No. 11/244

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.

Number of Pages in PDF File: 38

Keywords: Monetary policy, Bank rates, Profits, Interest rates on loans, Interest rates on deposits, Credit risk, Bank supervision

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Date posted: November 8, 2011  

Suggested Citation

Valencia, Fabián, Monetary Policy, Bank Leverage, and Financial Stability (October 2011). IMF Working Papers, Vol. , pp. 1-37, 2011. Available at SSRN: https://ssrn.com/abstract=1956391

Contact Information

Fabian V. Valencia (Contact Author)
International Monetary Fund (IMF) ( email )
700 19th Street, N.W.
Washington, DC 20431
United States
Princeton University ( email )
22 Chambers Street
Princeton, NJ 08544
United States

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