Reaching for Yield and the Diabolic Loop in a Monetary Union

Boubaker, S.; Gounopoulos, D.; Nguyen, D.K.; Paltalidis, N.

Abstract

We use the theoretical framework of Acharya and Naqvi (2019) to introduce a macro-financial model where the “reaching for yield” incentivized by a loosening monetary policy in the United States mitigates the diabolic loop in a Monetary Union. We provide empirical evidence that the introduction of an accommodative monetary policy by the Fed lowers the yields in US assets and increases liquidity and, by extension, the threshold above which a liquidity shock can damage a bank. This, in turn, incentivizes bank managers to optimize their portfolios by investing in risky assets. We use a monetary VAR to provide novel empirical evidence that there is an increase in the flow of funds to European assets, a result which can be attributed to the “reaching-for-yield” incentive. This portfolio balance channel attenuates the effects of financial fragility and improves government funding costs as well as credit conditions by providing liquidity to domestic banks and assets. As a result, the “reaching-for-yield” incentive mitigates the diabolic loop effect.

Citation

Boubaker, S., Gounopoulos, D., Nguyen, D., & Paltalidis, N. (2020). Reaching for Yield and the Diabolic Loop in a Monetary Union. Journal of International Money and Finance, 108, Article 102157. https://doi.org/10.1016/j.jimonfin.2020.102157

• Journal Article Type: Article
• Acceptance Date: Jan 29, 2020
• Online Publication Date: Feb 11, 2020
• Publication Date: 2020-11
• Deposit Date: Feb 1, 2020
• Publicly Available Date: Aug 11, 2021
• Journal: Journal of International Money and Finance
• Print ISSN: 0261-5606
• Electronic ISSN: 1873-0639
• Publisher: Elsevier
• Peer Reviewed: Peer Reviewed
• Volume: 108
• Article Number: 102157
• DOI: https://doi.org/10.1016/j.jimonfin.2020.102157
• Public URL: https://durham-repository.worktribe.com/output/1278300