DP11907 Financial Cycles with Heterogeneous Intermediaries

Author(s): Nuno Coimbra, Hélène Rey
Publication Date: March 2017
Keyword(s): banks, cycle, leverage, risk-shifting, systemic risk
JEL(s): E44, E58, G21
Programme Areas: Financial Economics, Monetary Economics and Fluctuations
Link to this Page: www.cepr.org/active/publications/discussion_papers/dp.php?dpno=11907

This paper develops a dynamic macroeconomic model with heterogeneous financial intermediaries and endogenous entry. It features time-varying endogenous macroeconomic risk that arises from the risk-shifting behaviour of financial intermediaries combined with entry and exit. We show that when interest rates are high, a decrease in interest rates stimulates investment and increases financial stability. In contrast, when interest rates are low, further stimulus can increase systemic risk and induce a fall in the risk premium through increased risk-shifting. In this case, the monetary authority faces a trade-off between stimulating the economy and financial stability.