The bank lending channel and monetary policy transmission when banks are risk averse

I develop a model to study how risk-averse banks use excess reserves to manage risk and how this behavior affects the way that exogenous shocks are transmitted through the aggregate economy. My most important finding is that the model I propose in this dissertation generates exogenous fluctuations in excess reserves over the business cycle. In particular, I find that the model predicts that risk-averse banks will accumulate excess reserves in response to an exogenous increase in loan defaults. This finding supports the hypothesis that risk-aversion among banks was at least partially responsible for the substantial build-up of excess reserves within the banking system during the financial crisis that preceded the Great Recession. I also find that the model that I propose complements the financial accelerator model of Bernanke, Gertler, and Gilchrist. The Bernanke et al. model is the canonical framework for representing how financial frictions influence the aggregate cycle and it is the foundation of the model that I develop in this dissertation. It is a strength of the model that I propose that it produces endogenous fluctuations in excess reserve holdings while still qualitatively preserving the transmission mechanisms from the Bernanke et al. model that govern how variables like output and inflation respond to exogenous shocks. Finally, I use the model of bank lending that I develop to characterize optimized interest rate rules for implementing monetary policy. I study several types of simple rules and I find that in general optimized monetary policy rules feature a relatively strong response to inflation and a muted response to output. These results are consistent with the optimized policy rules that have been reported in recent studies by Schmitt-Grohé; and Uribe and Kollmann