Reaching for Yield and the Diabolic Loop in a Monetary Union

Sabri Boubaker, Dimitrios Gounopoulos, Duc Nguyen, Nikos Paltalidis

Research output: Contribution to journalArticle

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.

Original languageEnglish
Article number102157
Number of pages42
JournalJournal of International Money and Finance
Early online date11 Feb 2020
DOIs
Publication statusE-pub ahead of print - 11 Feb 2020

Keywords

  • Diabolic loop
  • Financial intermediation
  • Sovereign debt

ASJC Scopus subject areas

  • Finance
  • Economics and Econometrics

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