DP10830 Search for Yield

Author(s): David Martinez-Miera, Rafael Repullo
Publication Date: September 2015
Keyword(s): bank monitoring, banking crises, boom and bust cycles, credit spreads, financial stability, real interest rates, savings glut, shadow banks
JEL(s): E44, G21, G23
Programme Areas: Financial Economics, International Macroeconomics and Finance
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=10830

We present a model of the connection between real interest rates, credit spreads, and the structure and the risk of the banking system. Banks intermediate between entrepreneurs and investors, and choose the monitoring intensity on entrepreneurs' projects. We characterize the equilibrium for a fixed aggregate supply of savings, showing that safer entrepreneurs will be funded by nonmonitoring (shadow) banks and riskier entrepreneurs by monitoring (traditional) banks. We also show that a savings glut reduces interest rates and spreads, increases the relative size of the shadow banking system and the probability of failure of the traditional banks. The model provides a framework for understanding the emergence of endogenous boom and bust cycles, as well as the procyclical nature of the shadow banking system, the existence of countercyclical risk premia, and the low levels of interest rates and spreads leading to the buildup of risks during booms.