Why Are Banks Exposed to Monetary Policy?†

American Economic Journal: Macroeconomics 2021, 13(4): 295–340 https://doi.org/10.1257/mac.20180379 By Sebastian Di Tella and Pablo Kurlat* We propose a model of banks’ exposure to movements in interest rates and their role in the transmission of monetary shocks. Since bank deposits provide liquidity, higher interest rates allow banks to earn larger spreads on deposits. Therefore, if risk aversion is higher than one, banks’ optimal dynamic hedging strategy is to take losses when interest rates rise. This risk exposure can be achieved by a tra- ditional maturity-mismatched balance sheet and amplifies the effects of monetary shocks on the cost of liquidity. The model can match the level, time pattern, and cross-sectional pattern of banks’ maturity mismatch. (JEL E43, E44, E51, E52, G21, G32) anks typically hamaturity-mismatched balance sheets, with ve long-duration nominal assets (lik fixe ed-rate mortg ages) and short-duration nominal liabilities (like deposits). This means that an increase in interest rates leads to a fall in banks’ net worth, measured in mark-to-market terms. In this paper, we argue that banks choose this exposure deliberately as part of a dynamic hedging strategy. We propose and quantify a model of risk sharing between banks and households and show that it can successfully explain banks’ average maturity mismatch, time-series its prop- erties, and the cross-sectional e vidence. It provides a laboratory to understand how monetary policy determines banks’ risk taking decisions. Our baseline model is a flexible-price monetary economy where the only source of shocks is monetary policy. The economy is populated by banks and households. The distinguishing feature of banks is that they are able to provide liquidity by issu- ing deposits that are close substitutes to currency, up to a leverage limit. Importantly, because markets are complete, banks are able to choose their exposure to risk inde- pendently...