Low interest rates, bank's search-for-yield behavior and financial portfolio management

We investigate the relationship between monetary policy and banks’ risk-taking behavior. We study a general equilibrium model in which a risk averse bank credits firms and also manages a portfolio consisting of a risky and a risk-free asset. When a bank signs up credit contracts with firms, it takes into account their solvency and potential gains from outside investment strategies. We show that the bank’s asset/liability and risk management depend on the prevailing policy rate. However, low policy rates incentivizes a bank to search-for-yield by re-allocating their asset portfolios towards more risky exposures ultimately leads to under-capitalized positions. This renders the financial sector more vulnerable.