Many theoretical central bank models use short horizons and focus on a single tradeoff. However, in reality, central banks play complex, long-horizon games and face more than one tradeoff. We account for these strategic interactions in a simple infinite-horizon game with a novel tradeoff: tighter monetary policy deters financial imbalances, but looser monetary policy reduces the likelihood of insolvency. We term these factors discipline and stability effects, respectively. The central bank's welfare decreases with dependence between real and financial shocks, so it may reduce costs with correlation-indexed securities. An independent central bank cannot in general attain both low inflation and financial stability.

A theoretical model of the borrower–lender relationship predicts that increased competitive threats lead to a reduction in loan covenant restrictiveness that is stronger for groups of borrowers who face constraints to their ability to raise external financing or compete in the product market. These predictions arise because competition impacts the dynamics of borrower performance so that lenders must trade off the benefit of controlling agency problems against a heightened cost of lost product market opportunities for the borrower, ultimately lowering the optimal use of covenants. We find strong empirical support for these predictions, highlighting an important role of competition for optimal financial contracting rooted in underlying agency problems.

Exploring bank-level data from a small open economy, we present evidence that global funding conditions limit the effectiveness of domestic monetary policy in terms of shaping both the volume and the riskiness of bank lending. We show that more favorable global funding conditions associated with a local currency appreciation encourage banks to increase lending, leverage up, take more risks, and thus insulate themselves from lean-against-the-wind domestic monetary policy. These results support the existence of a risk-taking channel of currency appreciation at the bank level.

This paper investigates how balance sheet opacity affects banks’ risk-taking behavior. We measure bank balance sheet opacity according to two metrics: the ratio of available-for-sale (AFS) securities and the ratio of off-balance sheet items. We show that balance sheet opacity is positively correlated with realized bank risk. Specifically, banks with more AFS securities have lower realized risk, while banks with more off-balance sheet items have higher realized risk. The correlation between opacity and risk depends on both macroeconomic variables and bank characteristics. The positive relationship between bank opacity and bank risk is weaker for better capitalized banks and banks that are subject to more market discipline. The relationship is also weaker during periods of favorable market conditions. Motivated by this analysis, we then investigate how regulation affects bank opacity. We show that higher capital requirements reduce bank opacity and bank risk through a portfolio rebalancing channel.

We explore the impact of low and negative monetary policy rates in core world economies on bank lending in four small open economies – Canada, Chile, the Czech Republic and Norway – using confidential bank-level data. We show that the impact on lending in these small open economies depends on the interest rate level in the core. During normal times, monetary policy cuts in the core can reduce credit supply in small open economies. In contrast, when interest rates in the core are low, further expansionary monetary policy increases lending in small open economies, consistent with an international bank lending channel. These results have important policy implications, suggesting that central banks in small open economies should watch for the impact of potential regime switches in core economies’ monetary policy when rates shift to and from the very low end of the distribution.