Monetary policy, bank leverage and systemic risk-taking

We examine the interplay between monetary policy, bank risk-taking, and financial stability in a quantitative macroeconomic model with endogenous risk-taking by banks and systemic crises. Banks’ access to leverage depends on their charter value, which is itself affected by movements in the real interest rate. We find that permanent shifts in the long-term real interest rate have a significant impact on banks’ leverage and on their investments in systemically risky assets, while transitory movements have a more limited impact. We show that in the presence of systemic risk-taking, the systemic component of monetary policy faces a trade-off between price stability and financial stability. A moderate reaction to inflation deviations from the target is optimal, as it sustains banks’ equity value after financial crises. Seeking price stability reduces inflation volatility but leads to increased systemic risk-taking and more severe financial recessions. The optimal central bank policy combination involves an increase in regulatory bank capital requirements coupled with a moderate reaction of monetary policy to inflation.