Bank market power and the risk channel of monetary policy

Do banks lend to riskier borrowers after a monetary expansion? We modify the classic costly state verification problem by introducing a risk-neutral monopolistic bank, which maximizes profits subject to borrowers’ participation. While the bank can diversify idiosyncratic default risk, it bears the aggregate risk. In partial equilibrium, the bank prefers a higher leverage ratio of the borrower, when the profitability of lending increases, e.g. after a monetary expansion. This risk channel persists in a New Keynesian DSGE model that replicates the conditional comovement in response to a monetary policy shock and the unconditional cross-correlations of bank-related variables in the data.