The Risk Channel of Monetary Policy

Oliver DeGroot
Authors registered in the RePEc Author Service: Oliver de Groot

No 2014-31, Finance and Economics Discussion Series from Board of Governors of the Federal Reserve System (U.S.)

Abstract: This paper examines how monetary policy affects the riskiness of the financial sector's aggregate balance sheet, a mechanism referred to as the risk channel of monetary policy. I study the risk channel in a DSGE model with nominal frictions and a banking sector that can issue both outside equity and debt, making banks' exposure to risk an endogenous choice, and dependent on the (monetary) policy environment. Banks' equilibrium portfolio choice is determined by solving the model around a risk-adjusted steady state. I find that banks reduce their reliance on debt finance and decrease leverage when monetary policy shocks are prevalent. A monetary policy reaction function that responds to movements in bank leverage or to movements in credit spreads can incentivize banks to increase their use of debt finance and increase leverage, ceteris paribus, increasing the riskiness of the financial sector for the real economy.

Keywords: Financial intermediation; portfolio choice; debt and equity; monetary policy; risk-adjusted steady state (search for similar items in EconPapers)
Pages: 30 pages
Date: 2014-04-09
New Economics Papers: this item is included in nep-cba, nep-dge, nep-mac and nep-mon
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (35)

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Related works:
Journal Article: The Risk Channel of Monetary Policy (2014)
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