Board of Governors of the Federal Reserve System

May 2014

The Risk Channel of Monetary Policy

Oliver de Groot

Abstract:

This paper examines how monetary policy affects the riskiness of the financial sector's aggregate balance sheet, a mechanism referred to as the risk channel of monetary policy. I study the risk channel in a DSGE model with nominal frictions and a banking sector that can issue both outside equity and debt, making banks' exposure to risk an endogenous choice, and dependent on the (monetary) policy environment. Banks' equilibrium portfolio choice is determined by solving the model around a risk-adjusted steady state. I find that banks reduce their reliance on debt finance and decrease leverage when monetary policy shocks are prevalent. A monetary policy reaction function that responds to movements in bank leverage or to movements in credit spreads can incentivize banks to increase their use of debt finance and increase leverage, ceteris paribus, increasing the riskiness of the financial sector for the real economy.

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Keywords: Financial intermediation, portfolio choice, debt and equity, monetary policy, risk-adjusted steady state

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