Reaching for Yield and the Diabolic Loop in a Monetary Union

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