Excessive Bank Risk Taking and Monetary Policy
34 Pages Posted: 20 Aug 2012
Date Written: August 13, 2012
Why should monetary policy 'lean against the wind'? Can’t bank regulation perform its task alone? We model banks that choose both asset volatility and leverage, and identify how monetary policy transmits to bank risk. Subsequently, we introduce a regulator whose tool is a risk-based capital requirement. We derive from welfare that the regulator trades off bank risk and credit supply, and show that monetary policy affects both sides of this trade-off. Hence, regulation cannot neutralize the policy rate’s impact, and monetary policy matters for financial stability. An extension shows how the commonality of bank exposures affects monetary transmission.
Keywords: macroprudential, leverage, supervision, monetary transmission
JEL Classification: E43, E52, E61, G01, G21, G28
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