Expansionary policy can also be expected to boost activity and profits, which also tends to raise asset prices. But the case for monetary policy having a role in the run-up to the crisis comes less from these conventional monetary transmission channels and more from the idea that loose monetary policy particularly encouraged a shift into riskier asset classes, which then got out of hand – the so-called “risk-taking channel” of monetary policy (Borio and Zhu, 2008). There are broadly three ways in which looser monetary policy encourages increased risktaking. First, and most conventionally, a lower yield on safe assets encourages substitution into higher-yielding risky assets, in the process driving up their prices. Second, some investors such as pension funds need to match the returns on their investments to their commitments. A reduction in the return on safe assets then encourages them to switch into high-yielding but riskier assets in an attempt to deliver nominal returns which match their liabilities – a “search for yield” (Rajan, 2005). Executive compensation linked to absolute returns has a similar effect. Finally, a slightly more complex mechanism is developed by Adrian and Shin (2009) and Adrian, Moench and Shin (2010). They argue that financial intermediaries target leverage ratios which are either constant (commercial banks) or pro-cyclical (investment banks).
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