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Monetary Policy, Bank Leverage, and Financial Stability

  • Fabian Valencia

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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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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  1. repec:dgr:kubcen:200931s is not listed on IDEAS
  2. Olivier Jeanne & Anton Korinek, 2010. "Managing Credit Booms and Busts: A Pigouvian Taxation Approach," Working Paper Series WP10-12, Peterson Institute for International Economics.
  3. Javier Bianchi & Enrique G. Mendoza, 2010. "Overborrowing, Financial Crises and 'Macro-prudential' Taxes," NBER Working Papers 16091, National Bureau of Economic Research, Inc.
  4. Javier Bianchi, 2010. "Credit Externalities: Macroeconomic Effects and Policy Implications," American Economic Review, American Economic Association, vol. 100(2), pages 398-402, May.
  5. repec:dgr:kubcen:2010108s is not listed on IDEAS
  6. Fabian Valencia, 2008. "Banks' Precautionary Capital and Credit Crunches," IMF Working Papers 08/248, International Monetary Fund.
  7. Ioannidou, V. & Ongena, S. & Peydro, J.L., 2009. "Monetary Policy, Risk-Taking, and Pricing : Evidence from a Quasi-Natural Experiment," Discussion Paper 2009-31 S, Tilburg University, Center for Economic Research.
  8. repec:imf:imfwpa:10/276 is not listed on IDEAS
  9. Skander Van den Heuvel, 2006. "The Bank Capital Channel of Monetary Policy," 2006 Meeting Papers 512, Society for Economic Dynamics.
  10. repec:dgr:kubcen:200775 is not listed on IDEAS
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