Bank Risk Taking & Quantitative Easing

In this paper, we investigate the long-run effects from central bank bond purchases onfinancial stability within a New Keynesian DSGE model with financial frictions. Banks havea portfolio choice between safe government bonds and risky corporate securities, and aresubject to limited liability. Bond purchases by the central bank induce banks to shift fromsafe bonds to risky securities, thereby increasing the probability of insolvency, everythingelse equal. However, bond purchases also lead to capital gains on banks’ existing assets,which reduces banks’ reliance on deposits. Moreover, a lower return on banks’ assets (asa result of the bond purchases by the central bank) decrease banks’ profitability, therebydecreasing depositors’ willingness to let banks operate with high leverage ratios. Our keyconclusion is that bond purchases also enhance financial stability in the long-run.