Working Paper

Bank Market Power and the Risk Channel of Monetary Policy

Abstract: This paper investigates the risk channel of monetary policy through banks' lending standards. We modify the classic costly state verification (CSV) problem by introducing a risk-neutral monopolistic bank, which maximizes profits subject to borrower participation. While the bank can diversify idiosyncratic default risk, it bears the aggregate risk. We show that, in partial equilibrium, the bank prefers a higher leverage ratio of borrowers, when the profitability of lending increases, e.g. after a monetary expansion. This risk channel persists when we embed our contract in a standard New Keynesian DSGE model. Using a factor-augmented vector autoregression (FAVAR) approach, we find that the model-implied impulse responses to a monetary policy shock replicate their empirical counterparts.

Keywords: Lending standards; Credit supply; Costly state verification; Risk channel; Monetary policy;

JEL Classification: D53; E44; E52;

https://doi.org/10.17016/FEDS.2018.006

Bibliographic Information

Provider: Board of Governors of the Federal Reserve System (U.S.)

Part of Series: Finance and Economics Discussion Series

Publication Date: 2018-01-19

Number: 2018-006