Reaching for Yield and the Diabolic Loop in a Monetary Union

Journal of International Money and Finance, Vol. 108, pp. 102-157, November 2020

41 Pages Posted: 13 Feb 2019 Last revised: 6 Jan 2021

See all articles by Sabri Boubaker

Sabri Boubaker

Ecole de Management de Normandie

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, Vol. 108, pp. 102-157, November 2020, Available at SSRN: https://ssrn.com/abstract=3323127 or http://dx.doi.org/10.2139/ssrn.3323127

Sabri Boubaker

Ecole de Management de Normandie ( email )

9 rue Claude Bloch
Le Havre Cedex, Cedex 4 14052 Caen
France

HOME PAGE: http://https://www.em-normandie.com/en/sabri-boubaker

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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