Reaching for Yield and the Diabolic Loop in a Monetary Union

Journal of International Money and Finance, Forthcoming

41 Pages Posted: 13 Feb 2019 Last revised: 2 Feb 2020

See all articles by Sabri Boubaker

Sabri Boubaker

University Paris-Est Créteil (UPEC) - Institut de Recherche en Gestion

Dimitrios Gounopoulos

University of Bath

Duc Khuong Nguyen

IPAG Business School

Nikos Paltalidis

Durham University Business School

Date Written: January 15, 2019

Abstract

We use the theoretical framework of Acharya and Naqvi (2019) to introduce a macro-financial model where the “reaching for yield” incentivized by a loosening monetary poli-cy in the United States mitigates the diabolic loop in a Monetary Union. We provide em-pirical evidence that the introduction of an accommodative monetary policy by the Fed lowers the yields in US assets and increases liquidity and, by extension, the threshold above which a liquidity shock can damage a bank. This, in turn, incentivizes bank manag-ers to optimize their portfolios by investing in risky assets. We use a monetary VAR to provide novel empirical evidence that there is an increase in the flow of funds to Europe-an assets, a result which can be attributed to the “reaching-for-yield” incentive. This port-folio balance channel attenuates the effects of financial fragility and improves government funding costs as well as credit conditions by providing liquidity to domestic banks and assets. As a result, the “reaching-for-yield” incentive mitigates the diabolic loop effect.

Keywords: Diabolic loop, Financial intermediation, Sovereign debt

JEL Classification: E51, E52, G21

Suggested Citation

Boubaker, Sabri and Gounopoulos, Dimitrios and Nguyen, Duc Khuong and Paltalidis, Nikos, Reaching for Yield and the Diabolic Loop in a Monetary Union (January 15, 2019). Journal of International Money and Finance, Forthcoming, Available at SSRN: https://ssrn.com/abstract=3323127 or http://dx.doi.org/10.2139/ssrn.3323127

Sabri Boubaker

University Paris-Est Créteil (UPEC) - Institut de Recherche en Gestion ( email )

61 Avenue du General de Gaulle
94010 Creteil
France

HOME PAGE: http://www.irg.u-pec.fr/enseignant.php?num=58

Dimitrios Gounopoulos

University of Bath ( email )

School of Management,
Wessex House, Claverton Down
Bath, BA2 7AY
United Kingdom

Duc Khuong Nguyen

IPAG Business School ( email )

184 BD Saint Germain
Paris, 75006
France

HOME PAGE: http://www.ipag.fr/en/

Nikos Paltalidis (Contact Author)

Durham University Business School ( email )

Mill Hill Lane
Durham, Durham DH1 3LB
United Kingdom

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