Low Interest Rates, Bank's Search-for-Yield Behavior and Financial Portfolio Management

We investigate the relationship between monetary policy and banks' risk-taking behavior.
We study a general equilibrium model in which a risk averse bank credits firms
and also manages a portfolio consisting of a risky and a risk-free asset. When a bank
signs up credit contracts with firms, it takes into account their solvency and potential
gains from outside investment strategies. We show that the bank's asset/liability and risk
management depend on the prevailing policy rate. However, low policy rates incentivizes
a bank to search-for-yield by re-allocating their asset portfolios towards more risky exposures
ultimately leads to under-capitalized positions. This renders the financial sector
more vulnerable.