Bank Market Power and the Risk Channel of Monetary Policy

89 Pages Posted: 1 Feb 2018 Last revised: 29 Apr 2020

See all articles by Elena Afanasyeva

Elena Afanasyeva

Board of Governors of the Federal Reserve System

Jochen Guntner

Johannes Kepler University

Date Written: 2018-01-19

Abstract

This paper investigates the risk channel of monetary policy through banks' lending standards. We modify the classic costly state verification (CSV) problem by introducing a risk-neutral monopolistic bank, which maximizes profits subject to borrower participation. While the bank can diversify idiosyncratic default risk, it bears the aggregate risk. We show that, in partial equilibrium, the bank prefers a higher leverage ratio of borrowers, when the profitability of lending increases, e.g. after a monetary expansion. This risk channel persists when we embed our contract in a standard New Keynesian DSGE model. Using a factor-augmented vector autoregression (FAVAR) approach, we find that the model-implied impulse responses to a monetary policy shock replicate their empirical counterparts.

Keywords: Lending standards, Credit supply, Costly state verification, Risk channel, Monetary policy

JEL Classification: D53, E44, E52

Suggested Citation

Afanasyeva, Elena and Guntner, Jochen, Bank Market Power and the Risk Channel of Monetary Policy (2018-01-19). FEDS Working Paper No. 2018-006, Available at SSRN: https://ssrn.com/abstract=3110531 or http://dx.doi.org/10.17016/FEDS.2018.006

Elena Afanasyeva (Contact Author)

Board of Governors of the Federal Reserve System ( email )

20th Street and Constitution Avenue NW
Washington, DC 20551
United States

Jochen Guntner

Johannes Kepler University ( email )

Linz
Austria

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