Monetary Policy, Bank Leverage, and Financial Stability

This paper develops a dynamic bank model to show that expansionary monetary shocks can increase bank risk-taking through higher leverage. Lower monetary policy rates increase lending profitability which can encourage the bank to take more leverage to finance new loans. In the presence of limited liability, the increase in leverage and risk can be excessive. However, the relationship can be non-monotonic. When the bank cannot issue equity, a small reduction in monetary policy rates can reduce excessive risk-taking, whereas a large one can increase it. When the bank can issue equity but adjusting dividends is costly, lower monetary policy rates always induce excessive risk-taking and the effect is quite persistent. In this model, capital requirements work better than loan-to-value caps in reducing excessive risk taking because they are closer to the source of the distortion