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Excessive bank risk taking and monetary policy

  • Agur, Itai
  • Demertzis, Maria

Why should monetary policy "lean against the wind"? Can’t bank regulation perform its task alone? We model banks that choose both asset volatility and leverage, and identify how monetary policy transmits to bank risk. Subsequently, we introduce a regulator whose tool is a risk-based capital requirement. We derive from welfare that the regulator trades off bank risk and credit supply, and show that monetary policy affects both sides of this trade-off. Hence, regulation cannot neutralize the policy rate’s impact, and monetary policy matters for financial stability. An extension shows how the commonality of bank exposures affects monetary transmission. JEL Classification: E43, E52, E61, G01, G21, G28

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Paper provided by European Central Bank in its series Working Paper Series with number 1457.

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Date of creation: Aug 2012
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Handle: RePEc:ecb:ecbwps:20121457
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