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Monetary Policy, Bank Leverage, and Financial Stability

Author/Editor: Fabian Valencia
Authorized for Distribution: October 1, 2011
Electronic Access: Free Full Text (PDF file size is 1,935KB)
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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.
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Series: Working Paper No. 11/244
Subject(s): Bank rates | Bank supervision | Credit risk | Financial stability | Interest rates on loans | Profits
Author's keyword(s): Financial Stability | Bank Leverage | Monetary Policy | Macroprudential regulation
    Published:   October 1, 2011        
    ISBN/ISSN:   9781463923235/1018-5941   Format:   Paper
    Stock No:   WPIEA2011244   Pages:   37
    Price:   US$18.00
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