Monetary Policy, Bank Leverage, and Financial Stability

41 Pages Posted: 5 Jul 2014  

Fabián Valencia

International Monetary Fund (IMF)

Multiple version iconThere are 3 versions of this paper

Date Written: July 3, 2014

Abstract

This paper develops a dynamic bank model to show that expansionary monetary shocks can increase bank risk-taking through higher leverage. Lower monetary policy rates increase lending profitability which can encourage the bank to take more leverage to finance new loans. In the presence of limited liability, the increase in leverage and risk can be excessive. However, the relationship can be non-monotonic. When the bank cannot issue equity, a small reduction in monetary policy rates can reduce excessive risk-taking, whereas a large one can increase it. When the bank can issue equity but adjusting dividends is costly, lower monetary policy rates always induce excessive risk-taking and the effect is quite persistent. In this model, capital requirements work better than loan-to-value caps in reducing excessive risk taking because they are closer to the source of the distortion.

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

JEL Classification: C61, E32, E44

Suggested Citation

Valencia, Fabián, Monetary Policy, Bank Leverage, and Financial Stability (July 3, 2014). Journal of Economic Dynamics and Control, Forthcoming. Available at SSRN: https://ssrn.com/abstract=2462289

Fabian V. Valencia (Contact Author)

International Monetary Fund (IMF) ( email )

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

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