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Bank Market Power and the Risk Channel of Monetary Policy

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Abstract

This paper investigates the risk channel of monetary policy through banks' lending standards. We modify the classic costly state verification (CSV) problem by introducing a risk-neutral monopolistic bank, which maximizes profits subject to borrower participation. While the bank can diversify idiosyncratic default risk, it bears the aggregate risk. We show that, in partial equilibrium, the bank prefers a higher leverage ratio of borrowers, when the profitability of lending increases, e.g. after a monetary expansion. This risk channel persists when we embed our contract in a standard New Keynesian DSGE model. Using a factor-augmented vector autoregression (FAVAR) approach, we find that the model-implied impulse responses to a monetary policy shock replicate their empirical counterparts.

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  • Elena Afanasyeva & Jochen Güntner, 2018. "Bank Market Power and the Risk Channel of Monetary Policy," Finance and Economics Discussion Series 2018-006, Board of Governors of the Federal Reserve System (U.S.).
    • Handle: RePEc:fip:fedgfe:2018-06
    DOI: 10.17016/FEDS.2018.006
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    Cited by:

    1. Durrani, Agha & Metzler, Julian & Michail, Nektarios & Werner, Johannes Gabriel, 2022. "Bank lending rates and the remuneration for risk: evidence from portfolio and loan level data," Working Paper Series 2753, European Central Bank.
    2. Abbate, Angela & Thaler, Dominik, 2023. "Optimal monetary policy with the risk-taking channel," European Economic Review, Elsevier, vol. 152(C).
    3. C. Bora Durdu & Molin Zhong, 2023. "Understanding Bank and Nonbank Credit Cycles: A Structural Exploration," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 55(1), pages 103-142, February.
    4. Ruitao Gu & Qiaoyun Zhang & Wei Zhou & Jianxu Liu, 2022. "Judging the True Health of Finance Institutions Based on Risk Behavior and Operation Performance," Mathematical Problems in Engineering, Hindawi, vol. 2022, pages 1-21, November.
    5. van der Kwaak, Christiaan & Madeira, João & Palma, Nuno, 2023. "The long-run effects of risk: an equilibrium approach," European Economic Review, Elsevier, vol. 153(C).
    6. Delis, Manthos D. & Iosifidi, Maria & Mylonidis, Nikolaos, 2021. "Industry heterogeneity in the risk-taking channel," Economic Modelling, Elsevier, vol. 104(C).
    7. Brana, Sophie & Campmas, Alexandra & Lapteacru, Ion, 2019. "(Un)Conventional monetary policy and bank risk-taking: A nonlinear relationship," Economic Modelling, Elsevier, vol. 81(C), pages 576-593.
    8. Heider, Florian & Leonello, Agnese, 2021. "Monetary Policy in a Low Interest Rate Environment: Reversal Rate and Risk-Taking," Working Paper Series 2593, European Central Bank.
    9. Colletaz, Gilbert & Levieuge, Grégory & Popescu, Alexandra, 2018. "Monetary policy and long-run systemic risk-taking," Journal of Economic Dynamics and Control, Elsevier, vol. 86(C), pages 165-184.
    10. Elena Afanasyeva, 2020. "Can Forecast Errors Predict Financial Crises? Exploring the Properties of a New Multivariate Credit Gap," Finance and Economics Discussion Series 2020-045, Board of Governors of the Federal Reserve System (U.S.).
    11. Elena Afanasyeva & Sam Jerow & Seung Jung Lee & Michele Modugno, 2020. "Sowing the Seeds of Financial Imbalances: The Role of Macroeconomic Performance," Finance and Economics Discussion Series 2020-028, Board of Governors of the Federal Reserve System (U.S.).

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    More about this item

    Keywords

    Lending standards; Credit supply; Costly state verification; Risk channel; Monetary policy;
    All these keywords.

    JEL classification:

    • D53 - Microeconomics - - General Equilibrium and Disequilibrium - - - Financial Markets
    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy

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