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 set up a simple model in which a risk averse bank awards loans to firms and also manages a financial investment 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 under risk aversion, in contrast to the standard approach of risk neutral preferences. We show that the bank's asset/liability and risk management depend on the prevailing risk-free policy rate. However, low policy rates incentivize a bank to engage into a search-for-yield by re-allocating their asset portfolios towards more risky exposures that ultimately leads to under-capitalized positions, and to an increased financial sector vulnerability.