Monetary Policy, Bank Leverage and Systemic Risk-Taking

Abstract

We study the effect of changes to the long-run real interest rate on banks' risk-taking incentives. To assess this question, we build a macroeconomic model with nominal rigidities, monetary policy, and endogenous bank systemic risk-taking. Banks' access to leverage depends on their charter value, which is itself affected by movements in the real interest rate. We show that permanent shifts in the long-term real interest rate have a significant impact on bank leverage and on banks' investments in systemically risky assets. In contrast, transitory movements in real interest rates have a more limited impact. We find that in the presence of systemic risk-taking, a moderate response to inflation is optimal as it sustains banks' capital during crisis. Responding strongly to inflation deviations from target reduces the volatility of inflation but leads to more bank systemic risk-taking and more severe financial crises. Once bank capital ratios are optimally set, systemic risk-taking is significantly reduced and price stability is once again optimal.

Keywords: financial intermediation, monetary policy, bank risk-taking, macroprudential policy

JEL Classification: E44, E52, E58, G21