A DSGE Model with Endogenous Bank Risk-Taking

The bank risk-taking channel is the empirical regularity according to which bank risk increases after monetary policy easing. Dell’Ariccia, Laeven and Marquez (2014) provide a theoretical framework that explains the channel’s foundations. In their partial equilibrium context, banks’ optimal choice of risk is influenced by changes in banks’ margins originating from monetary policy decisions. There are three subordinate effects through which monetary policy influences margins. Until now, no DSGE model includes all three channels. For central banks, this deficit is relevant. They desire models with endogenous bank risk-taking.

I provide a DSGE model incorporating all three effects. To do so, I extend the seminal Gerali et al. (2010) model. Subsequently, I study the model’s propagation mechanism. I depict its endogenous responses in bank risk-taking to monetary policy and TFP shocks. I contribute narrative VAR evidence as a reference. The results are: First, the DSGE model retains the ability to match stylized responses in output and inflation to the two shocks. Second, in terms of risk-taking, the model’s IRFs closely match the patterns and timing of narrative VAR evidence. Banks respond to monetary policy tightening by initially decreasing risk-taking. Subsequently, bank risk shows a temporary hump-shaped increase. In response to a TFP shock, bank risk-taking initially increases and then reverts to its steady state. The model correctly incorporates all three effects into the propagation mechanism. Overall, the model performs well.

Subsequently, I successfully apply the model to provide further insights into the pass-through effect. To achieve this, I refine Dell’Ariccia, Laeven and Marquez’s considerations. Banking market competition determines the pass-through effect either through the elasticity of substitution or through interest rate stickiness. Via these two characteristics of competition, competition may exert opposite influences on the pass-through effect and thus on bank risk-taking. From the perspective of the elasticity of substitution, bank risk-taking should decline more in response to monetary policy tightening in markets which are more competitive. From the perspective of interest rate stickiness, bank risk-taking should decline more in response to monetary policy tightening in markets that are less competitive. However, the influences upon bank risk-taking are small. The influence of competition is stronger in entrepreneurial loan markets as compared to household loan markets. One reason for the small influence is this. In a general equilibrium model, banking market competition influences the risk-shifting effect via the optimal leverage effect. The pass-through effect’s influence is thus offset.


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