The Risk-Taking Channel of Banks' Debt and Monetary Policy

Abstract

We study the implications of liquidity regulations and monetary policy on deposit-making and risk-taking. Banks give risky loans by creating deposits that firms use to pay suppliers. Firms and banks can take more or less risk. In equilibrium, higher liquidity requirements always lower risk at the cost of lowering investment. Nevertheless, a positive liquidity requirement is always optimal. Monetary conditions affect the optimal size of liquidity requirements, and the optimal size is countercyclical. It is optimal to impose a 100% liquidity requirement when inflation is sufficiently low and a positive but less than 100% requirement when inflation is high.