Capital flows and the risk-taking channel of monetary policy

This paper examines the relationship between low interests maintained by advanced economy central banks and credit booms in emerging economies. In a model with crossborder banking, low funding rates increase credit supply, but the initial shock is amplified through the “risk-taking channel” of monetary policy where greater risk-taking interact with dampened measured risks that are driven by currency appreciation to create a feedback loop. In an empirical investigation using VAR analysis, we find that expectations of lower short-term rates dampens measured risks and stimulate cross-border banking sector capital flows.