Monetary Policy, Bank Leverage, and Financial Stability

Fabian Valencia

No 2011/244, IMF Working Papers from International Monetary Fund

Abstract: 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.

Keywords: WP; interest rate; monetary policy; Financial Stability; Bank Leverage; Macroprudential regulation; bank capital; bank default risk; capital requirement; B. bank-depositor contract; capital-to-assets ratio; borrower-bank contract; A. bank-borrower loan contract; bank fragility; Debt default; Central bank policy rate; Loans; Self-employment; Bank credit (search for similar items in EconPapers)
Pages: 37
Date: 2011-10-01
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Citations: View citations in EconPapers (16)

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