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Federal Reserve Bank of Chicago

Financial Stability Considerations
for Monetary Policy:
Theoretical Mechanisms
Andrea Ajello, Nina Boyarchenko, Francois
Gourio, and Andrea Tambalotti

February 2022
WP 2022-06
https://doi.org/10.21033/wp-2022-06
Working papers are not edited, and all opinions and errors are the
responsibility of the author(s). The views expressed do not necessarily
reflect the views of the Federal Reserve Bank of Chicago or the Federal
Reserve System.
*

Financial Stability Considerations for Monetary Policy:
Theoretical Mechanisms
Andrea Ajello, Nina Boyarchenko, Francois Gourio, and Andrea Tambalotti 1
February 2022
Abstract
This paper reviews the theoretical literature at the intersection of macroeconomics and finance to
draw lessons on the connection between vulnerabilities in the financial system and the
macroeconomy, and on how monetary policy affects that connection. This literature finds that
financial vulnerabilities are inherent to financial systems and tend to be procyclical. Moreover,
financial vulnerabilities amplify the effects of adverse shocks to the economy, so that even a small
shock to fundamentals or a small revision of beliefs can create a self-reinforcing feedback loop
that impairs credit provision, lowers asset prices, and depresses economic activity and inflation.
Finally, monetary policy may affect the buildup of vulnerabilities, but the sign of the impact along
some of its transmission channels is theoretically ambiguous and may vary with the state of the
economy.

JEL codes: E32, E44, E58, G2
Keywords: monetary policy, financial stability, financial crises, credit, leverage, liquidity, asset
prices.

1

The views expressed in this paper are those of the authors and do not necessarily reflect the position of the Board
of Governors of the Federal Reserve, the Federal Reserve Banks of Chicago or New York, or the Federal Reserve
System. The authors thank Ozge Akinci, Gadi Barlevy, Richard Clarida, Rochelle Edge, Marc Giannoni, Luca
Guerrieri, David Lopez-Salido, Elizabeth Klee, Anna Kovner, Sylvain Leduc, Paolo Pesenti, Ned Prescott, Matthew
Pritsker, Bruno Sultanum, Tom Tallarini, John Williams, and the audience at the Systemwide Symposium on
Financial Stability Considerations for Monetary Policy for comments on previous drafts of the paper. Russell Miles
and Hunter Wieman provided excellent research assistance. Emails (and affiliations): andrea.ajello@frb.gov
(Federal Reserve Board of Governors); nina.boyarchenko@ny.frb.org (Federal Reserve Bank of New York and
CEPR); francois.gourio@chi.frb.org (Federal Reserve Bank of Chicago); andrea.tambalotti@ny.frb.org (Federal
Reserve Bank of New York).

1

I.

Introduction

This paper reviews the theoretical macro-finance literature to draw lessons on the connection
between vulnerabilities in the financial system and the macroeconomy, and on how monetary
policy affects that connection.2 This review focuses on the analysis of the connections, taking a
“positive” approach in the current monetary and regulatory environment, and deliberately
abstracts from the “normative” analysis of the trade-offs in setting monetary policy.
We draw three main lessons from this literature. First, financial vulnerabilities are inherent to
financial systems and tend to be procyclical. The financial system enables households and firms
to borrow and lend, and to diversify and manage risks, supporting economic activity through
credit, maturity, and liquidity transformation. When combined with information asymmetries or
other frictions, these transformations may lead to the emergence of financial vulnerabilities.
Financial vulnerabilities can accumulate over the course of economic expansions, especially
when asymmetric information or other frictions, coupled with potentially irrational beliefs, lead
to an underestimation and/or an underpricing of risk, and ultimately to higher risk-taking.
Second, financial vulnerabilities amplify the effects of adverse shocks to the economy. Given
high leverage, elevated asset prices, and substantial liquidity or maturity mismatch, even a small
shock to fundamentals or a revision of beliefs can create a self-reinforcing feedback loop that
impairs credit provision, lowers asset prices, and depresses economic activity and inflation.
Finally, monetary policy can affect the buildup of vulnerabilities. As part of its standard
transmission channels, monetary policy affects asset prices, lending and risk-taking by financial
institutions, and borrowers’ balance sheets, and hence overall vulnerabilities. However, the sign
of some of these effects is theoretically ambiguous and may vary with the state of the economy.
Overall, the literature we survey suggests that the academic consensus has evolved since the
2007-2009 financial crisis to recognize that financial vulnerabilities have the potential to
adversely affect the real economy, and that monetary policy may contribute to their accumulation
over the business cycle and at longer frequencies.

2

A glossary at the end of this paper defines the concepts of financial instability, financial vulnerabilities, net
financial vulnerabilities, and financial conditions.

2

We also highlight a number of as-yet-unresolved issues that call for more research. First, the
nonlinear interactions between monetary policy, financial stability, and macroeconomic
outcomes are technically challenging to model and hard to estimate empirically, making definite
quantitative conclusions on their relevance difficult. Furthermore, while we focus here on
vulnerabilities which remain after accounting for the overall resilience of the financial system—
often referred to as net vulnerabilities – the structure of the financial system (including macroprudential and supervisory policies) may also affect the connections between monetary policy,
financial stability, and macroeconomic outcomes.
Second, while many studies consider whether financial vulnerabilities are more likely to emerge
in a low interest rate environment, more work is needed to understand how this relationship
depends on the source of low interest rates. Conceptually, variation in the level of interest rates
can arise from four types of sources: (a) secular variation in the “neutral” interest rate (such as
the current “low r*” environment); (b) cyclical variation in the neutral rate (arising for example
from productivity or demand fluctuations); (c) the overall conduct of monetary policy as a
systematic response to economic outcomes, including potentially financial conditions; (d)
monetary policy surprises i.e. deviations from this perceived systematic response. These sources
of variation in interest rates potentially act through different channels: for example, the perceived
systematic conduct of policy could affect financial vulnerabilities not only directly through
current interest rates, but also through their influence on households’, firms’, and investors’
policy expectations and behavior. Separating these sources empirically is challenging;
Boyarchenko et al. (2022) discuss the lessons that can be learned from the empirical literature on
financial vulnerabilities and monetary policy.
There are several other reviews of these topics. 3 The emphasis in our review is on mechanisms
that are relevant for the U.S. financial system, which is less bank-centric than many, and we also
emphasize more recent research, including research that incorporates nonlinearities, tail risk, and
behavioral frictions.
The rest of the paper is organized as follows. Section II reviews why vulnerabilities arise in the
financial system. Section III discusses how vulnerabilities can affect the real economy. Section

3

Smets (2014), Kashyap and Siegert (2020), Adrian and Liang (2018), Stein (2021), Goldberg et al. (2020).

3

IV studies how monetary policy affects vulnerabilities. Section V discusses some gaps in the
literature.
II.

Financial Vulnerabilities Are Inherent to Financial Systems

The financial system facilitates transactions between borrowers and savers. Frictions such as
incomplete information, however, can lead to financing decisions that are privately, but not
socially, optimal, and that can often generate financial vulnerabilities. This section reviews
theories of financial vulnerabilities. These theories highlight how frictions create
interdependencies between real activity, its financing, and monetary policy. As the financial
system intermediates credit and finances real activity, it performs two key functions that can lead
to the build-up of vulnerabilities: (1) credit risk transformation through leverage, and (2)
maturity and liquidity transformation.
Credit risk transformation takes place when risky assets are financed with debt. In theory,
without frictions, financing decisions do not affect the value of a project. 4 In practice, they do
because of private information, agency costs, tax advantages of debt, and other market
imperfections. Consequently, debt contracts can be privately, but not socially, optimal because
individual borrowers ignore the effect of their decisions on others. For example, future defaults
can be associated with bankruptcy costs, forced deleveraging can create fire sales, and spending
reductions due to financial constraints can create aggregate demand externalities (as described in
section III).5
These individually optimal debt choices affect how borrowing evolves with the state of the
economy, creating a “borrowing cycle”. In expansions, borrowing may increase due to shifts in
either credit supply—for example, due to an increase in savings by wealthy households and
firms—or credit demand—for example, due to optimism about future productivity growth. 6
These theories all predict a procyclical borrowing cycle, with debt increasing during economic
expansions, but disagree on the implications for the cyclicality of leverage – defined as the ratio
4

Modigliani and Miller (1958).
Jensen and Meckling (1976), Townsend (1979), Gale and Hellwig (1985), Harris and Raviv (1990), Winton
(1995), and Park (2000) are some of the early theories of the private optimality of debt contracts.
6
For models of increasing credit demand in expansions, see Bordalo et al. (2018); Bordalo et al., (2021);
Krishnamurthy and Li, (2020); Maxted (2020). For models of increasing credit supply, see Mian, Straub and Sufi
(forthcoming), Boz and Mendoza (2014); Bolton, Santos and Scheinkman (2021).
5

4

of assets to equity. As discussed in Boyarchenko et al. (2022), the leverage of most U.S.
financial institutions is procyclical. From a theoretical perspective, leverage is procyclical when
there is a self-reinforcing feedback between asset prices and leverage: higher asset prices
increase the value of assets held by financial institutions and the amount that they can borrow
against each dollar of those assets, leading to even more leverage and further asset price
increases.7
Borrowing cycles can be amplified if risk is underpriced in booms either because of a low
perceived exposure of borrowers and savers’ balance sheets to shocks (the “quantity of risk”), or
because constraints are less binding and risk-taking by financial institutions increases, reducing
the compensation that market participants require for being exposed to shocks (the “price of
risk”).8 Incentives, financial frictions and beliefs interact: when optimism boosts asset prices,
borrowing is easier, and incentives can become distorted, leading to increased lending.
Expectations of policy support in the event of a financial recession can also encourage agents to
take on more risk in anticipation of it, further boosting asset prices and lowering risk premia. 9
In addition to credit risk transformation through leverage, financial institutions may also engage
in maturity and liquidity transformation, creating funding vulnerabilities. Banks transform liquid
short term deposits into illiquid loans with long maturities. This transformation makes banks
vulnerable to sudden belief reversals, which can trigger runs, even when the value of banks’
assets is greater than that of their liabilities.10 Funding vulnerabilities are also relevant for nonbanks, with the same mechanism of funding withdrawals leading to self-fulfilling runs. 11
Changes in the provision of maturity and liquidity transformation over the business cycle have

7

Geanakoplos (1997, 2010), Fostel and Geanakoplos (2008, 2014), Brunnermeier and Pedersen (2009), Adrian and
Shin (2010, 2014), Adrian and Boyarchenko (2012, 2013), and Adrian and Duarte (2020). Asset prices can increase
because of changes in investors’ beliefs about either the fundamental (Brunnermeier and Pedersen, 2009) or the
resale value of assets (Scheinkman and Xiong (2003), Barlevy (2007), Brunnermeier and Oehmke (2013a)).
Leverage is countercyclical in Kiyotaki and Moore (1997), Bernanke and Gertler (1989), Bernanke, Gertler and
Gilchrist (1999), Carlstrom and Fuerst (1997), He and Krishnamurthy (2012, 2013), and Brunnermeier and
Sannikov (2014).
8
Additionally, falling franchise values may encourage risk-taking by financial institutions due to limited liability
and government guarantees (Keeley (1990); Gomes, Grotteria and Wachter (2018)).
9
See also Minsky (1972), Kindleberger (1991), Allen and Gale (2000b).
10
In the Diamond and Dybvig (1983) model, deposit insurance prevents runs and is socially optimal. This
conclusion, however, rests on the assumption that banks cannot adjust the riskiness of their balance sheets. In
contrast, Kareken and Wallace (1978) study the moral hazard problem induced by deposit insurance and show that
deposit insurance may lead to more risk taking and, hence, more fragile banks.
11
Acharya, Gale, and Yorulmazer (2011), Huang and Ratnovski (2011), Parlatore (2016), Foley-Fisher et al. (2020).

5

not been the subject of many theoretical models, but some work has argued that the ability to
issue longer-maturity and, thereby, less runnable debt is impaired during economic downturns,
and more so for more levered firms. 12
The sources of financial vulnerabilities discussed in this section serve as building blocks for
models that explore the connection between financial stability and real activity. We discuss these
models next.
III.

Financial Vulnerabilities and Real Outcomes

This section reviews how financial vulnerabilities affect the real economy in expansions and
especially in recessions. We start by discussing traditional (or “first-generation”) treatments of the
financial accelerator mechanism, in which leverage amplifies business cycles. We then turn to
recent extensions, which highlight how leverage can generate asymmetric macroeconomic tail
risks. We then consider additional amplification channels created by maturity and liquidity
transformation as well as by equity-financed asset price bubbles.
III.1 The Financial Accelerator
Leverage amplifies and propagates the response of the economy to aggregate shocks. Borrowers
must pay a premium when they raise funding to compensate their lenders for taking on credit risk.
Because this credit risk depends on borrowers’ net worth (or equity) and collateral values,
borrowers’ balance sheets are a crucial determinant of the credit conditions they face.
If negative shocks lead to more precarious balance sheets, credit terms worsen, forcing borrowers
to reduce their debt and level of activity. This retrenchment weakens aggregate economic activity,
thus propagating the shock. In addition, persistently lower economic activity depresses asset
prices, reducing the value of borrowers’ assets, which further magnifies their balance sheet
distress. This is the so-called financial accelerator. 13
The first generation of financial accelerator models focused on non-financial business leverage,
but the mechanism they illustrate also applies to other borrowers, such as households and financial

12

See, for example, He and Milbradt (2016).
This mechanism was spelled out in the seminal contributions of Bernanke and Gertler (1989), Bernanke et al.
(1999), Carlstrom and Fuerst (1997) and Kiyotaki and Moore (1997).
13

6

institutions.14 The financial accelerator also explains why shocks that originate within the financial
sector can persistently lower aggregate output and asset prices. 15 Two characteristics of the
traditional financial accelerator diverge from what is typically observed about financial
vulnerabilities, however. First, these models do not speak to the systematic relationship between
financial vulnerabilities and the phases of the business and financial cycles, therefore missing the
link between financial vulnerabilities and the risks to the outlook. Second, they do not generate
the abrupt financial crises that are the most recognizable manifestations of financial instability.
III.2. Asymmetric Tail Risk
More recent treatments of the financial accelerator mechanism start from similar economic
assumptions but focus on the cumulative effects of macroeconomic shocks on the entire
distribution of future economic outcomes, including the possibility of financial crises, and on how
those effects depend on the current state of the financial sector. 16 In these models, the economy
can be in a “normal” or a “crisis” state depending on financial intermediaries’ equity. In the
“normal” state, equity is sufficient to absorb moderate shocks. In the “crisis” state, in contrast,
even small shocks lead to fire sales, amplifying the adverse feedback loop between lower net worth
and lower asset prices. In this environment, therefore, the effect of shocks can depend on financial
vulnerabilities. In addition, the theory points to a “volatility paradox:” lower fundamental
volatility, as during the Great Moderation, leads to higher leverage, which in turn supports buoyant
asset valuations. However, the resulting increase in vulnerabilities can lead to more extreme
volatility spikes and macroeconomic disruptions in response to shocks.
III.3 Vulnerabilities Other Than Leverage

14

For models of financial frictions in household mortgage borrowing, see Iacoviello (2005). For models with
financial frictions on financial intermediaries, see Gertler and Kiyotaki (2010) and Gertler and Karadi (2011).
Holmstrom and Tirole (1997) and Meh and Moran (2010) present models that combine borrowing frictions for both
financial and non-financial agents.
15
The models of Jermann and Quadrini (2012), Christiano, Motto and Rostagno (2014), Ajello (2016) and Del Negro
et al. (2017) feature so-called “financial” or “risk” shocks. These can be thought of as credit supply shocks since they
increase intermediation frictions by worsening agency problems.
16
These “second generation” models focus on nonlinear dynamics rather than on first-order approximations. See for
instance, Mendoza (2010), Adrian and Boyarchenko (2012, 2013), He and Krishnamurthy (2013, 2014),
Brunnermeier and Sannikov (2014), Akinci and Queralto (Forthcoming), and Akinci et al. (2021).

7

The non-linear dynamics described above can be further exacerbated by the possibility of runs,
whose sudden and discrete nature is one of the key features of financial crises. 17 In models of the
financial accelerator that also feature liquidity and maturity transformation, run risk is higher when
intermediaries are highly leveraged, since even small liquidity demand shocks can start a run which
then becomes self-fulfilling. Runs can thus interact with standard financial accelerator effects,
translating maturity or liquidity mismatch together with leverage into macroeconomic instability. 18
The interconnected nature of financial systems can also lead to nonlinear amplification. A more
interconnected financial system can share risks more efficiently, but this risk-sharing property also
facilitates propagation of shocks, opening the door to cascading defaults (the “domino effect”). In
this case, the mere fear of individual failures can reduce trade between intermediaries, and hence
impair the efficient allocation of liquidity and funding. 19
Finally, it is unclear if asset price increases financed with equity, rather than debt, create
vulnerabilities. On the one hand, asset bubbles may be useful, for instance because they alleviate
borrowing constraints, spurring investment and innovation. 20 On the other hand, bubbles are
inherently fragile, and might be disruptive when they burst, especially if downward wage rigidity
prevents wages from adjusting during the bust, or if interest rates are constrained by the effective
lower bound (ELB).21

17

Gertler, Kiyotaki and Prestipino (2020) and Gertler and Kiyotaki (2015) are models of the financial accelerator
that include potential bank runs.
18
Gorton and Ordonez (2014, 2020) argue that crises can also arise suddenly when investors shift from presuming
that all assets are of high quality to evaluating and sorting them more closely, which uncovers the low credit quality
that has built up over time.
19
See Allen and Gale (2000a), Freixas et al. (2000), Shin (2009), Boissay et al. (2016), Nier et al. (2007),
Acemoglu, Ozdaglar and Tahbaz-Salehi (2015). Haldane (2009) calls this feature of networks a “robust-but-fragile”
property.
20
Samuelson (1958) and Diamond (1965) also show that asset bubbles can be beneficial if savings are excessive
(“dynamic inefficiency”).
21
For papers discussing the potentially positive effects of bubbles, see Samuelson (1958), Diamond (1965), Martin
and Ventura (2012, 2016), Miao, Shen and Wang (2019), Farhi and Tirole (2012b), Morck (2021), Haddad et al.
(2020). For papers emphasizing more the negative effects, see e.g. Biswas et al. (2020) and the references cited
therein.

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IV. The Impact of Monetary Policy on Financial Vulnerabilities
This section reviews theories of how monetary policy can influence the emergence and build-up
of financial vulnerabilities described in Section II. 22 A compendium table summarizing the
content of Section IV is available in the Appendix.
Many classic theories of monetary policy transmission imply an impact on vulnerabilities as
expansionary monetary policy works to lower the price of credit and boost its quantity, thus
affecting interest rates and asset prices (the interest rate and asset price channels). By lifting
asset prices and lowering the price of credit, monetary policy boosts the net worth and financial
soundness of borrowers (the balance sheet channel), as well as the ability of financial
intermediaries to borrow and supply credit (the bank lending channel), encouraging risk-taking
(through reach-for-yield) and the build-up of leverage. Finally, we highlight how policy aimed
at affecting market participants’ expectations about the macroeconomic outlook (via the
information or signaling channel) can amplify policy transmission.
IV.1 Interest Rate and Asset Price Channels
Monetary policy works through the asset-price channel by affecting the expected path of shortterm rates and future cash flows. In addition, monetary policy can impact risk premia by
changing aggregate uncertainty and market participants’ perception of risks.
There is no dominant theory of the forces that drive risk premia and the role that monetary policy
plays in shaping their dynamics. For instance, in many macro-finance models, the systematic
component of monetary policy affects risk premia by influencing the distribution of future
macroeconomic outcomes.23 As discussed later in this section, loose monetary policy can also

22

This paper does not address how monetary policy can partially alleviate the consequences of a financial recession
(i.e., “ex-post” policy), and hence reduce the consequences of financial vulnerabilities. The ability of monetary
policy to “limit the damage” depends on several factors. On the one hand, easier monetary policy can directly
respond to financial stress by boosting asset prices and reducing debt burdens (e.g., Gomes et al. (2016)). On the
other hand, the transmission of monetary policy might be impaired if the financial sector does not fully pass-through
financing conditions to the rest of the economy, either because of financial institutions’ debt overhang (e.g., Wieland
and Yang (2020)), or because borrowers can’t refinance due to lower asset values (e.g., Alpanda and Zubairy
(2019)). In addition, monetary policy might become less effective because private spending becomes less interest
rate sensitive, due to uncertainty (Bloom 2014), or to a desire to deleverage. Finally, financial recessions can depress
the natural rate of interest, making the ELB a more binding constraint, as in Eggertsson and Krugman (2012).
23
For example, a reduction in the systematic response of monetary policy to inflation might expose longer-term
nominal debt claims to more inflation risk, raising the term premium that marker participants require to hold such
assets, as in Rudebusch and Swanson (2012), Campbell, Pflueger, Viceira (2020), and Kung (2015).

9

indirectly support asset valuations by boosting leverage and the demand for collateral. In some
models, a credit expansion fueled by loose monetary policy can also foster an asset price
bubble.24
Monetary policy can also boost asset prices above their fundamentals by influencing the beliefs
of market participants who are not fully rational and may become overly optimistic about the
outlook during booms and overly pessimistic during downturns. 25 Monetary policy can also
compress risk premia by redistributing wealth between agents with different propensities to take
on risk: easier policy can lower risk premia by boosting the value of the portfolios of wealthy,
leveraged market participants. Such investors tend to be more optimistic or less risk-averse than
the average investor and ultimately bid up risky asset valuations by requiring a lower premium to
increase their holdings.26
IV.2 Balance Sheet Channel
The literature on the balance sheet channel focuses on the effect of monetary policy on the
balance sheet of borrowers and on their demand for credit. In the financial accelerator models
described in section III, the net effect of monetary policy on financial vulnerabilities via the
balance sheet channel is ambiguous. On the one hand, easier monetary policy may lead to a
build-up of financial vulnerabilities by encouraging debt issuance, as market participants borrow
against higher asset valuations to finance their purchase of long-maturity, illiquid, or risky assets.
On the other, lower interest rates and the associated higher output and inflation can facilitate the
deleveraging of indebted firms or financial intermediaries, and/or refinancing of their existing
debt at lower rates, reducing vulnerabilities.27

24

In Allen and Gale (2010), lenders have limited information and control over how investors use borrowed funds.
Investors therefore can take on profitable leveraged bets on risky assets, bidding up their price above fundamentals,
while shifting risk on the lenders’ balance sheet. Generally, monetary models of asset price bubbles suggest that
tighter monetary policy and higher borrowing costs reduce the size of bubbles and their macroeconomic
consequences. In Dong, Miao, and Wang (2020) and Biswas, Hanson, and Phan (2020), for instance, tighter
monetary policy can reduce the volatility of the bubble and prevent prolonged economic recessions once the bubble
bursts. Gali (2014, 2021) reaches the opposite conclusion in a model in which the short-term policy rate helps pin
down the growth rate of asset price bubbles, finding that systematic tightening in response to a rational asset price
bubble can increase its volatility. This result, however, appears to rely on an arbitrary equilibrium selection (Miao,
Shen and Wang (2019)).
25
For instance, Krishanmurthy and Li (2020).
26
For instance, Kekre and Lenel (2020).
27
In the first-generation models described in section III.1, leverage decreases in response to monetary policy easing,
at least in the short run, effectively reducing balance sheet vulnerabilities despite the increase in debt issuance.

10

The models with tail risk reviewed in section III.2 highlight additional channels through which
monetary policy might seed crises. Such models imply that transmission of easier monetary
policy via the balance sheet channel increases net vulnerabilities and risks to the real outlook. 28
Lower real interest rates, while improving financial conditions, boosting asset valuations and
supporting real activity in the short run, can encourage a gradual increase in risky lending to the
private sector, and an endogenous build-up of leverage that makes the system more vulnerable in
the longer-run.29
Monetary policy might also prove less effective as a macroeconomic stabilization tool if the
economy becomes over-leveraged. As policymakers ease the monetary policy stance in response
to a deteriorating macroeconomic outlook, borrowers issue debt and set aside increasing
resources to service it, thereby transferring wealth to lenders who are more likely to save than to
consume. In the medium run, such transfers dampen the effect of monetary policy easing on
aggregate spending.30 Under this premise, accommodative monetary policy is likely to increase
financial vulnerabilities, as it raises the debt servicing burden while failing to boost indebted
demand, increasing the odds that the economy will further underperform as policy becomes
constrained at the ELB.
IV.3 Bank Lending Channel and Reach-for-Yield
The literature on the bank lending channel focuses on the effect of monetary policy on the supply
of bank credit.31 Banks engage in credit and maturity transformation by borrowing funds at
shorter maturities and extending risky longer-maturity loans. Accommodative monetary policy
reduces the cost of funding for banks, and thus may increase reliance on debt by banks and by
the nonfinancial sector, encouraging the build-up of vulnerabilities that stem from credit and
maturity transformation. 32

28

See for example Akinci, Benigno, Del Negro and Queralto (2021), and recent extensions that assume deviations
from rational expectations such as Krishnamurthy and Li (2020). Most of these models assume flexible prices and
thus ignore inflation. One recent exception is Adrian and Duarte (2020).
29
In their model with tail risk, Coimbra and Rey (2020) find that this result depends on overall financing conditions:
lower real interest rates stimulate investment and entry by less levered financial institutions when initial interest
rates are high—thus reducing vulnerabilities. Lower real interest rates instead can induce risk shifting and stimulate
entry by more levered financial institutions when initial interest rates are low—thus increasing vulnerabilities.
30
Mian, Straub, and Sufi (forthcoming).
31
Bernanke and Blinder (1988).
32
Stein (2012).

11

Banks and, more generally, investors can exhibit “reach-for-yield” behavior when they increase
the risk of their portfolio with the objective of partially offsetting the income loss from low rates.
Easier monetary policy may reduce bank net interest margins, potentially leading to an easing of
bank lending standards and an increase in risk-taking. 33 In the short run, a higher propensity to
take risk reduces the cost of funding real activity and can support the macroeconomic outlook. In
this respect reach-for-yield is arguably part of the standard transmission of monetary policy. 34
However, reach-for-yield can increase financial vulnerabilities through the balance sheet of
lenders, insofar as risky projects deliver disappointing returns and trigger fire sales and
bankruptcies as the macroeconomic outlook deteriorates. At the same time, reach-for-yield may
reduce vulnerabilities on the balance sheets of borrowers, as relaxed credit standards provide
borrowers with increased flexibility in response to adverse shocks.
An important share of borrowing and lending takes place in nonbank financial institutions, which
may exhibit similar behavior to banks but can be more prone to excessive leverage and risktaking, partly because they are less affected by regulatory requirements than traditional banks.
That said, few models are able to rationalize reach-for-yield behavior without institutional or
regulatory constraints. For example, endowments or sovereign funds are often required to pay
out (no more than) the expected yield on their portfolio. 35 When interest rates fall, the portfolio
yield drops and investors face a reduction in payouts. Rebalancing portfolios toward riskier
assets with a higher expected return can mitigate the drop in payouts. 36 Other theories emphasize
agency issues—e.g., mutual funds may seek to attract naïve retail investors by displaying a high
yield—often in combination with deviations from rationality, such as nominal illusion. 37
33

Banks’ balance sheets are also exposed to funding (or liquidity) risk. Banks hold reserves and other liquid assets
as a precautionary buffer, trading off loan profits and insurance against sudden withdrawals of deposits. Lower
interest rates reduce both banks’ cost of funding and the return on safe assets. On the one hand, accommodative
monetary policy can help banks that face liquidity shortages by easing their financing conditions and reducing
liquidity risk. On the other hand, lower returns on safe assets may encourage reach-for-yield, as banks rebalance
their portfolios toward more profitable risky assets thereby increasing leverage and maturity risk (Dreschler,
Schnabl, and Savov (2018), Bianchi and Bigio (forthcoming)).
34
Dell’Ariccia, Laeven, and Marquez (2010), De Groot (2014), and Silva (2016) also discuss the effect of monetary
policy easing on financial institutions’ risk-taking and portfolio rebalancing toward riskier assets.
35
Campbell and Sigalov (2021).
36
This effect is stronger when interest rates are low because the payout constraint is more likely to bind.
37
Retail investors may be attracted by high advertised yield because they do not fully understand the risk that
accompanies those yields, or they may be anchored to higher rates due to historical reference points (Lian et al.
(2019)). The spread between the risky rate and the risk-free rate may also be more salient when rates are low (e.g., a

12

While low yields may encourage portfolio rebalancing toward riskier assets, lower interest rates
are likely to lead to reach-for-yield only if institutional constraints remain static and investors fail
to learn or to refine their investment strategies. Moreover, reach-for-yield behavior might be
amplified when interest rates are expected to remain persistently low, for instance due to secular
declines in r*, rather than to cyclical changes connected with monetary policy stabilization.
IV.4

Expectations and Signaling Channels

An additional channel through which monetary policy may affect vulnerabilities is by shaping
market participants’ expectations about future macroeconomic outcomes and about the future
stance of monetary policy. In both cases, forward guidance might reinforce the channels of
transmission described in this section, through lower levels of interest rates and lower
uncertainty about future monetary policy decisions. More broadly, the monetary policy regime
shapes these expectations powerfully: a monetary policy that responds strongly to the real
outlook and financial conditions, in particular if it is perceived to respond asymmetrically to
declines in asset values, can lead to risk underpricing, more risk-taking, and in the end increased
vulnerabilities.38 On the contrary, a policy that does not respond as strongly to the real outlook
and financial conditions may discourage leverage excessively, and may increase vulnerabilities
by making debt less sustainable.39
V. Conclusions and gaps in the literature
Most of the theoretical models remain somewhat stylized, abstracting from important features of
the economy. First, most models abstract from inflation dynamics and simplify the monetary
environment. Second, most macro-financial frameworks focus on a single representative
intermediary, subject to a specific financial constraint, thus ignoring the diversity of financial
entities that exist in the U.S., and the unique features of each type of institutions. Third,
quantitative models of the interactions between financial vulnerabilities and real outcomes are in
5% return is more attractive relative to a 1% return than 10% is relative to 6%). Mutual funds or hedge funds may
also reach-for-yield because lower interest rates affect the likelihood of beating their benchmark and hence influence
their fees (Rajan, 2005). Underwater insurance companies and pension funds may take more risk in order to cover
their funding shortfall. Banks may also have incentives to take on more risk because of lower franchise value in a
world where interest rates (or the slope of the yield curve) are low. Martinez-Miera and Repullo (2017) show that a
savings glut that leads to lower interest rates causes an expansion of “low monitoring” lending with higher risk
overall.
38
Bordo and Jeanne (2002), Borio and Lowe (2002), Diamond and Rajan (2012), Farhi and Tirole (2012a).
39
Bornstein and Lorenzoni (2018), Korinek and Jeanne (2020). See also Koenig (2013) and Sheedy (2014).

13

their infancy. For example, most models do not capture the predictability of financial crises
documented in the empirical literature.
Fourth, monetary policy has theoretically ambiguous effects on financial vulnerabilities. Low
interest rates can help firms improve their balance sheets and increase their credit worthiness.
However, they may also spur the accumulation of leverage and encourage reach-for-yield
behavior. The theoretical models reviewed here tend to showcase the effects of policy on
vulnerabilities in isolation rather than discussing their net contributions or assessing tradeoffs
across different types of vulnerabilities. Overall, while most theoretical mechanisms discussed
above imply that easier monetary policy tends to increase vulnerabilities, the strength of this
relationship also depends on the level of financial regulation and the state of macroprudential
policy, and on the economic outlook. Moreover, even if monetary policy unambiguously
increases vulnerabilities, this may be desirable if the level of vulnerabilities is inefficiently low
in the first place, for instance in the early stage of a recovery.
Finally, there is limited theoretical work on how financial vulnerabilities accumulate over
durations longer than the business cycle, thus abstracting from the longer horizons of financial
cycles that have been identified in the empirical literature. Understanding this asynchronicity
between the financial and business cycles could be crucial for a full evaluation of the effect of
monetary policy on financial vulnerabilities.

14

Glossary


Financial instability is the propensity of the financial system—defined broadly to
include financial intermediaries, financial markets, payment systems and the central bank
—to amplify negative shocks that originate in the real economy or to be a source of
shocks itself, both with large negative consequences for the macroeconomy. A stable
financial system can withstand most shocks with minimal added disruptions to the real
economy.



Financial vulnerabilities are features of the financial system that make it less stable.
They represent exposures to shocks and evolve over time at frequencies that potentially
differ from those of business cycles.



Financial conditions provide a timely indicator of the current state of the business and
financial cycles and are distinct from financial vulnerabilities. Whether financial
conditions are accommodative or tight may not have direct bearing on whether a financial
system is stable or unstable.



Net financial vulnerabilities are those vulnerabilities that remain after taking into
account the regulatory and supervisory environments.

15

Table. Transmission Mechanisms of Monetary Policy to Financial Vulnerabilities
Contributions

Affected Vulnerabilities
Effect of Policy Easing
Models of Systematic Monetary Policy and Risk Premia
Rudebusch and Swanson
Asset Valuations
Ambiguous: A lower Taylor rule coefficient
(2012), Campbell,
on inflation might expose nominal debt assets
Pflueger, Viceira (2020),
to increased inflation risk, increasing nominal
Kung (2015), Gourio
term premium. Conversely, a stronger
and Ngo (2020)
response of policy to real variables could
compress real risk premia. ELB acts as a
constraint to systematic stabilization of
disinflationary demand shocks—for which
nominal bonds are a hedge—and can
contribute to the compression of nominal
term premia.

Literature inspired by
Kiyotaki and Moore
(1997), Bernanke,
Gertler, Gilchrist (1999)

Allen and Gale (2010)
Interest Rate
and Asset Price
Channels

Models with Financial Accelerator
Asset Valuations
Increase: Monetary policy easing can support
asset valuations by encouraging lending and
the demand for collateral assets. Higher
collateral value further boosts lending and
economic activity (see Balance Sheet
Channel below for the effect on leverage).
Models of Asset Price Bubbles
Asset Valuations
Increase: If lenders have limited information
and control over how investors use borrowed
funds, low rates encourage investors to take
on profitable leveraged bets on risky assets,
bidding up their price above fundamentals
while shifting risk on lenders’ balance sheets.

Dong, Miao, and Wang
(2020), Biswas, Hanson,
Phan (2020)

Asset Valuations

Increase: Borrowers subject to credit
constraints value bubbles because they are
liquid and can be used as store of value to
take on future investment opportunities when
credit is scarce. Higher inflation can erode
borrowers’ net worth, tighten credit
constraints, and fuel the bubble. Easier
policy, by boosting inflation, increases the
size of the bubble.

Galí (2014, 2021)

Asset Valuations

Decrease: Systematic policy easing lowers
asset returns and decreases the growth rate
and volatility of bubbles.

Krishanmurthy and Li
(2020)

Models with Non-Rational Beliefs
Asset Valuations
Increase: Monetary policy may boost asset
prices above fundamentals by influencing
beliefs of investors, who become overly
optimistic about the outlook during booms
and too pessimistic during downturns.
Models of Asset Prices and Inequality

16

Kekre and Lenel
(Forthcoming)

Literature inspired by
Kiyotaki and Moore
(1997), Bernanke,
Gertler, Gilchrist (1999)

Increase: Monetary policy can compress risk
premia by redistributing wealth to rich,
leveraged market participants who are more
prone to take risk.
Affected Vulnerabilities
Effect of Policy Easing
Models with Financial Accelerator
Non-Financial Leverage
Ambiguous: Easier monetary policy may lead
to a build-up of financial vulnerabilities by
encouraging debt issuance, as market
participants borrow against higher asset
valuations to finance long-maturity, illiquid,
or risky assets. Conversely, lower interest
rates, together with the associated higher
output and inflation, can also facilitate
deleveraging and/or refinancing of existing
debt at lower rates, reducing vulnerabilities.

Akinci, Benigno, Del
Negro and Queralto
(2021)
Krishnamurthy and Li
(2021)
Adrian and Duarte
(2020)

Models with Financial Accelerator and Tail Risk
Non-Financial and
Increase (longer-term): Lower real interest
Financial Leverage
rates, while improving financial conditions,
boosting asset valuations and supporting real
activity in the short run, can encourage a
gradual increase in risky lending to the
private sector, and an endogenous build-up of
leverage that makes the system more
vulnerable to shocks in the longer run.

Contributions

Balance Sheet
Channel

Coimbra and Rey (2020)

Mian, Straub, and Sufi
(forthcoming)

Asset Valuations

Non-Financial and
Financial Leverage

Ambiguous: When interest rates are initially
high, lower real interest rates stimulate
investment and entry by less levered financial
institutions when initial interest rates are
high—thus reducing vulnerabilities. When
interest rates are initially low, lower interest
rates instead can induce risk shifting and
stimulates entry by more levered financial
institutions when initial interest rates are
low—thus increasing vulnerabilities.

Models with Inequality
Non-Financial Leverage
Increase: Easier policy in response to a
deteriorating outlook encourages borrowers to
issue debt and set aside increasing resources
to service it, thereby transferring wealth to
lenders who are more likely to save than to
consume. As leverage vulnerabilities rise, r*
falls and monetary policy proves less
effective as a macroeconomic stabilization
tool.

17

Contributions
Bernanke and Blinder
(1988)
Stein (2012)

Affected Vulnerabilities
Financial Leverage

Effect of Policy Easing
Increase: Accommodative monetary policy
reduces the cost of funding and thus may
increase reliance on debt by banks and by the
nonfinancial sector, encouraging the build-up
of vulnerabilities that stem from credit and
maturity transformation

Dell’Ariccia, Laeven,
and Marquez (2010), De
Groot (2014), and Silva
(2016)

Financial Leverage,
Maturity, and Liquidity
Transformation

Increase: Easier monetary policy may reduce
bank net interest margins, potentially leading
to easier bank lending standards and more
risk-taking.

Bank Lending
Channel

Dreschler, Schnabl, and
Savov (2018), Bianchi
and Bigio (forthcoming)

Models with Liquidity Risk
Financial Leverage and
Ambiguous: Accommodative monetary
Liquidity Transformation policy can help banks that face liquidity
shortages by easing their financing conditions
and reducing liquidity risk. Alternately,
lower returns on safe assets may encourage
reach-for-yield, as banks rebalance their
portfolios toward more profitable risky assets
thereby increasing leverage and maturity risk

Reach-for-yield

Models with Regulatory Constraints, Agency Frictions, or Non-Rational Beliefs
Campbell and Sigalov
Financial Leverage,
Increase: Increased risk-taking occurs in low(2021), Lian et al.
Maturity, and Liquidity
rate environments as rebalancing portfolios
(2019), Rajan (2005),
Transformation
toward riskier assets with a higher expected
Martinez-Miera and
return can mitigate the drop in portfolio
Repullo (2017)
returns.
Reach-for-yield might increase with lower
rates if:
- funds’ payout constraints are likely to bind
due to nominal hurdle rates,
- investors’ expectations are anchored to
historical higher returns,
- mutual funds pursue higher returns to beat
their benchmark and earn fees.
- franchise value of banks decreases and they
bet on risky investments for resurrection.
Interest rates that are structurally low might
affect reach for yield more than temporary
monetary policy accommodation.

18

Expectations
and Signaling
Channels

Bordo and Jeanne
(2002), Diamond and
Rajan (2012), Bornstein
and Lorenzoni (2018),
Korinek and Jeanne
(2020), Benigno et al.
(2013)

All

Amplification of other channels: Monetary
policy may affect vulnerabilities by shaping
expectations about future macro outcomes
and about the future stance of policy.
Forward guidance might reinforce the
channels of transmission described above,
through lower levels of interest rates and
lower uncertainty not just about current but
also future monetary policy decisions.

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