This paper shows that a rate hike has countervailing effects on banks’ risk appetite. It reduces risk when the debt burden of the banking sector is modest. We model a regulator whose trade-off between bank risk and credit supply is derived from a welfare function. We show that the regulator cannot optimally neutralize the welfare effects that the interest rate has through bank incentives. The larger the correlation between banks’ projects, the more important the role for monetary policy. In a dynamic setting, not internalizing bank risk leads a monetary authority to keep rates low for too long after a negative shock.
Keywords: Monetary policy, Financial stability, Maturity mismatch, Leverage, Regulation.
JEL Classification: E43, E52, E61, G01, G21, G28.