Monetary Policy and Systemic Risk

Abstract

We employ an event study approach to estimate the price reaction of U.S. financial stocks to 147 Federal Open Market Committee (FOMC) decisions about the Fed funds target rate for the period 2000-2015. We show that systemic risk tends to increase abnormal returns for announcements related to a positive unexpected change in the target rate (“Positive Surprise”). On the other hand, systemic risk tends to reduce abnormal returns for dates related to a “Negative Surprise” and a “Zero Surprise” (the announced rate is the same as the expected one). These results suggest that a higher than expected target rate can be advantageous to institutions with high levels of systemic risk. High short-term interest rates and a flat yield curve can increase the risk of a crisis, and therefore this finding could be explained by a “Too-Big-To-Fail (TBTF) hypothesis”: whenever the likelihood of a systemic crisis increases, investors buy stocks of financial firms that are more likely to be rescued.