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Monetary Policy, Bank Leverage, and Financial Stability

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  • Fabian Valencia

Abstract

This paper develops a model to assess how monetary policy rates affect bank risk-taking. In the model, a reduction in the risk-free rate increases lending profitability by reducing funding costs and increasing the surplus the monopolistic bank extracts from borrowers. Under limited liability, this increased profitability affects only upside returns, inducing the bank to take excessive leverage and hence risk. Excessive risk-taking increases as the interest rate decreases. At a broader level, the model illustrates how a benign macroeconomic environment can lead to excessive risk-taking, and thus it highlights a role for macroprudential regulation.

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Bibliographic Info

Paper provided by International Monetary Fund in its series IMF Working Papers with number 11/244.

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Length: 37
Date of creation: 01 Oct 2011
Date of revision:
Handle: RePEc:imf:imfwpa:11/244

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Keywords: Financial stability; Bank rates; Profits; Interest rates on loans; Credit risk; Bank supervision; bank capital; capital requirements; risk of default; bank default; bank risk; bankrupt; probability of default; recapitalization; risk aversion; bank risk-taking; bank profits; banking; bank contracts; bank defaults; risk taking; banking sector; monetary authority; state bank; bank loans; prudential regulation; bank behavior; arbitrage; bank collects; bank profitability; bank fragility; bank shares; bank risk taking;

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References

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  1. Jeanne, O. & Korinek, A., 2010. "Managing Credit Booms and Busts: A Pigouvian Taxation Approach," Discussion Paper, Tilburg University, Center for Economic Research 2010-108S, Tilburg University, Center for Economic Research.
  2. Ioannidou, V. & Ongena, S. & Peydro, J.L., 2009. "Monetary Policy, Risk-Taking, and Pricing: Evidence from a Quasi-Natural Experiment," Discussion Paper, Tilburg University, Center for Economic Research 2009-31 S, Tilburg University, Center for Economic Research.
  3. Enrique Mendoza & Javier Bianchi, 2010. "Overborrowing, financial crises and ‘macro-prudential’ taxes," Proceedings, Federal Reserve Bank of San Francisco, Federal Reserve Bank of San Francisco, issue Oct.
  4. Giovanni Dell'Ariccia & Robert Marquez & Luc Laeven, 2010. "Monetary Policy, Leverage, and Bank Risk-Taking," IMF Working Papers 10/276, International Monetary Fund.
  5. Javier Bianchi, 2010. "Credit Externalities: Macroeconomic Effects and Policy Implications," American Economic Review, American Economic Association, American Economic Association, vol. 100(2), pages 398-402, May.
  6. Jiminez, G. & Ongena, S. & Saurina, J., 2007. "Hazardous Times for Monetary Policy: What do Twenty-three Million Bank Loans Say about the Effects of Monetary Policy on Credit Risk?," Discussion Paper, Tilburg University, Center for Economic Research 2007-75, Tilburg University, Center for Economic Research.
  7. Fabian Valencia, 2008. "Banks' Precautionary Capital and Credit Crunches," IMF Working Papers 08/248, International Monetary Fund.
  8. Skander Van den Heuvel, 2006. "The Bank Capital Channel of Monetary Policy," 2006 Meeting Papers, Society for Economic Dynamics 512, Society for Economic Dynamics.
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Citations

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Cited by:
  1. Ekin Ayse Ozsuca & Elif Akbostanci, 2012. "An Empirical Analysis of the Risk Taking Channel of Monetary Policy in Turkey," ERC Working Papers, ERC - Economic Research Center, Middle East Technical University 1208, ERC - Economic Research Center, Middle East Technical University, revised Dec 2012.
  2. Itai Agur & Maria Demertzis, 2011. ""Leaning Against the Wind" and the Timing of Monetary Pollicy," DNB Working Papers, Netherlands Central Bank, Research Department 303, Netherlands Central Bank, Research Department.
  3. Angela Maddalonia & Jose-Luis Peydro, 2013. "Monetary Policy, macroprudential Policy, and Banking Stability: Evidence from the Euro Area," International Journal of Central Banking, International Journal of Central Banking, International Journal of Central Banking, vol. 9(1), pages 121-169, March.
  4. Agur, Itai & Demertzis, Maria, 2012. "Excessive bank risk taking and monetary policy," Working Paper Series, European Central Bank 1457, European Central Bank.
  5. Delis, Manthos D & Hasan, Iftekhar & Mylonidis, Nikolaos, 2011. "The risk-taking channel of monetary policy in the USA: Evidence from micro-level data," MPRA Paper 34084, University Library of Munich, Germany.

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