Monetary Policy, Bank Leverage, and Financial Stability

October 1, 2011

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Format: Chicago

Fabian Valencia. Monetary Policy, Bank Leverage, and Financial Stability, (USA: International Monetary Fund, 2011) accessed November 21, 2024

Disclaimer: This Working Paper should not be reported as representing the views of the IMF.The views expressed in this Working Paper are those of the author(s) and do not necessarily represent those of the IMF or IMF policy. Working Papers describe research in progress by the author(s) and are published to elicit comments and to further debate

Summary

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.

Subject: Bank credit, Banking, Central bank policy rate, Debt default, External debt, Financial institutions, Financial services, Labor, Loans, Money, Self-employment

Keywords: A. bank-borrower loan contract, B. bank-depositor contract, Bank capital, Bank credit, Bank default risk, Bank fragility, Bank Leverage, Borrower-bank contract, Capital requirement, Capital-to-assets ratio, Central bank policy rate, Debt default, Financial Stability, Interest rate, Loans, Macroprudential regulation, Monetary policy, Self-employment, WP

Publication Details

Pages:

37
Volume:

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DOI:

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Issue:

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Series:

Working Paper No. 2011/244
Stock No:

WPIEA2011244
ISBN:

9781463923235
ISSN:

1018-5941

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