Liquidity, Term Spreads and Monetary Policy

Abstract

We propose a model that delivers endogenous variations in term spreads driven by banks’ portfolio decision while facing the risk of maturity transformation. First, we show that fluctuations of the future profitability of banks’ portfolios affect their ability to cover for any liquidity needs and hence influence the premium banks require to carry the maturity risk. When economic activity is reaching its peak, expected profitability is relatively high and spreads are low; during a recession expected profitability is relatively low and spreads are high, in line with the time series properties of term spreads. Second, we use the model to look at unconventional monetary policy and show that allowing banks to sell long-term assets to the central bank after a liquidity shock creates a new channel of policy transmission that leads to a sharp decrease in term spreads. Such interventions have significant impact on long-term investment, decreasing the amplitude of output responses after a liquidity shock. The shortterm rate does not need to decrease as much as when only conventional policies are implemented and the resulting inflation turns out to be higher. Finally, we provide econometric evidence on the link between expected financial business profitability and yield spreads.