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Monetary policy, bank leverage, and financial stability

Fabian Valencia ()

Journal of Economic Dynamics and Control, 2014, vol. 47, issue C, 20-38

Abstract: This paper shows that with limited liability banks lever up excessively to finance new loans. Lower monetary policy rates can worsen or reduce these incentives depending on the size of the shock when equity financing is ruled out. When this constrained is relaxed but the bank faces costly dividend adjustment, lower monetary policy rates always worsen risk-taking incentives and the effect is persistent. The reason is that costly dividend adjustment lowers the opportunity cost of lending. In this model, capital requirements are closer to the source of the distortion and thus work better than loan-to-value caps in reducing excessive risk taking.

Keywords: Financial stability; Bank leverage; Risk-taking; Monetary policy; Macroprudential regulation (search for similar items in EconPapers)
JEL-codes: C61 E32 E44 (search for similar items in EconPapers)
Date: 2014
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DOI: 10.1016/j.jedc.2014.07.010

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Journal of Economic Dynamics and Control is currently edited by J. Bullard, C. Chiarella, H. Dawid, C. H. Hommes, P. Klein and C. Otrok

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