Systemic Risk Implication of Monetary Policies: A Functional Local Projection Analysis

This paper investigates the causal relationship between monetary policy and financial instability. Employing a novel approach known as the functional local projection, we comprehensively analyze the impact of both conventional and unconventional monetary policy actions on systemic risks, across pre- and post-QE periods. Our findings reveal that functional monetary policy shocks imply fluctuations of systemic risks in the short term, which lead to financial instability in the medium run. Further evidence suggests that the impact of monetary policy on systemic risks is mainly driven by the banking sector, as the non-bank financial sector appears to be less sensitive to policy shocks. These results carry significant implications for the design and implementation of monetary policies, especially for economies characterized by a substantial financial sector.