Academic journal article Brookings Papers on Economic Activity

Effects of Unconventional Monetary Policy on Financial Institutions

Academic journal article Brookings Papers on Economic Activity

Effects of Unconventional Monetary Policy on Financial Institutions

Article excerpt

ABSTRACT Monetary policy affects the real economy in part through its effects on financial institutions. High-frequency event studies show that the introduction of unconventional monetary policy in the winter of 2008-09 had a strong, beneficial impact on banks and, especially, on life insurance companies. I interpret the positive effects on life insurers as evidence that expansionary policy helped to recapitalize the sector by raising the value of legacy assets. Expansionary policy had small positive or neutral effects on banks and life insurers during the period 2010-13. The interaction of low nominal interest rates and administrative costs forced money market funds to waive fees, producing a possible incentive to reach for yield to reduce waivers. I show that money market funds with higher costs did reach for higher returns in 2009-11, but not thereafter. Some private defined-benefit pension funds increased their risk taking beginning in 2009, but again such behavior largely dissipated by 2012. In sum, unconventional monetary policy helped to stabilize some sectors and provoked modest additional risk taking in others. I do not find evidence that riskiness of the financial institutions studied fomented a trade-off between expansionary policy and financial stability at the end of 2013.

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In the winter of 2008, the Federal Reserve's Federal Open Market Committee (FOMC) began using a mix of policy instruments unprecedented in its history. This mix expanded to eventually include a target federal funds rate of essentially zero, purchases of Treasury bonds, purchases of agency mortgage-backed securities (from Fannie Mae, Freddie Mac, and Ginnie Mae), purchases of agency bonds, and explicit guidance concerning the future path of the federal funds rate. I refer to this mix of instruments as unconventional monetary policy. The FOMC introduced these policies with the intention of reducing long-term real interest rates, which it believed would lead to a stronger economic recovery. (1) A number of studies have since confirmed the success in reducing long-term rates (Gagnon and others 2010; Krishnamurthy and Vissing-Jorgensen 2011; Campbell and others 2012; Wright 2012).

The introduction of new treatments raises concern about side effects. In the aftermath of one of the worst financial crises in history, a possibly acute side effect involves the health and stability of the financial sector. Indeed, numerous FOMC participants have cited increased risk taking by financial institutions as a potential constraint on their policy choices (Bernanke 2013; Stein 2013a; Fisher 2014). Alternatively, an improving real economy spurred in part by the unconventional policy may have helped to stabilize some financial institutions.

In this paper I discuss four channels through which unconventional monetary policy affects the financial sector. First, reducing the risk-free rate lowers the hurdle rate for risky investment projects. This leads to increased new spending on projects with either lower mean returns or higher variances. Depending on the distribution of newly funded projects, the optimal level of real risk in the economy may change. Financial institutions carry exposure to real project risk through their role as intermediaries between borrowers and savers. Second, unconventional policy may lead some financial institutions to seek higher returns, due to institutional dissatisfaction with low yields. By definition, such "reaching for yield" constitutes an increase in risk taking beyond what the end holders of the risk would prefer. Third, by promoting recovery in the real economy, unconventional policy lowers delinquency and default rates, raises profits, and possibly lowers risk aversion. Higher probability of payoff, higher profits, or less risk aversion each implies higher prices of legacy assets (financial assets already on financial institutions' balance sheets), and this improves solvency. These general equilibrium effects may also benefit financial companies that sell products with a positive income elasticity. …

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