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Monetary Shocks and Bank Balance Sheets

Author

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  • Sebastian Di Tella

    (Stanford GSB)

  • Pablo Kurlat

    (Stanford University)

Abstract

We propose a model to explain why banks' balances sheets are exposed to interest rate risk despite the existence of markets where that risk can be hedged. A rise in nominal interest rates raises the opportunity cost of holding currency; since bank liabilities are close substitutes of currency, demand for bank liabilities rises and banks earn higher spreads. If risk aversion is higher than 1, the optimal dynamic hedging strategy is to sustain capital losses when nominal interest rates rise and, conversely, capital gains when they fall. A traditional bank balance sheet with long duration nominal assets achieves that.

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  • Sebastian Di Tella & Pablo Kurlat, 2015. "Monetary Shocks and Bank Balance Sheets," 2015 Meeting Papers 650, Society for Economic Dynamics.
    • Handle: RePEc:red:sed015:650
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    References listed on IDEAS

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    1. Cox, John C & Ingersoll, Jonathan E, Jr & Ross, Stephen A, 1985. "An Intertemporal General Equilibrium Model of Asset Prices," Econometrica, Econometric Society, vol. 53(2), pages 363-384, March.
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