Editor’s Note: This article is based on our research paper “Liquidity Regulation and the Implementation of Monetary Policy” and on the extended discussion in BIS Working Paper No. 432.2. It also draws heavily on a recent discussion paper, which presents some of the arguments in more detail.
The liquidity coverage ratio (LCR) component of Basel III introduces new international standards for regulating and evaluating banks’ liquidity. It gives banks incentives to hold more liquid assets and to limit their reliance on very-short-term funding. As with any new regulation, the LCR may have unintended consequences, potentially creating new challenges. One concern is that by changing the structure of short-term interest rates, the LCR might interfere with the way central banks implement monetary policy. In this article, we describe how such interference could arise and how the Federal Reserve and other central banks might, if needed, change their monetary policy procedures to overcome it.
Implementing Monetary Policy
Over time, central banks have developed operating procedures that let them closely control short-term market interest rates. In the U.S., the Federal Open Market Committee (FOMC) sets a target for the federal funds rate, which is the interest rate on unsecured, overnight loans between banks and certain other financial institutions. It then instructs the Open Market Desk at the Federal Reserve Bank of New York to take action to steer the market interest rate to this target level. Prior to 2008, the Desk used daily open market operations to change the supply of reserve balances available to the banking system. In recent years, the Fed has instead relied on changing the interest rate it pays on bank reserves and on overnight reverse-repurchase agreements to raise market interest rates. While the Fed has not committed itself to a framework for implementing monetary policy in the future, it has offered some guidance indicating that it will continue to focus on controlling a short-term interest rate, such as the federal funds rate.
By changing the federal funds rate, the Fed aims to induce shifts in the longer-term interest rates that are relevant for firms and consumers. The process of implementing monetary policy thus relies on changes in the federal funds rate being reliably transmitted through financial markets to these longer-term rates. At times, this transmission process has not worked as desired. In 2005, for example, Alan Greenspan famously described the fact that longer-term interest rates were falling even though the FOMC had repeatedly raised its target for the federal funds rate as a “conundrum.” For the most part, however, central banks have been successful in using changes in a short-term interest rate to influence broader financial conditions and thereby to implement monetary policy effectively.
Introducing Liquidity Regulation
The LCR will potentially create an additional “wedge” in this transmission mechanism for monetary policy. To see why, we need to examine how the new regulation changes banks’ incentives to borrow and lend in money markets. The LCR requires each subject bank to hold a sufficient quantity of high-quality liquid assets (HQLA) to cover the net cash outflows (NCOF) it would experience in a 30-day stress event. This requirement is often written as a ratio:
Instead of working directly with this ratio, it is useful to instead write the requirement in terms of the bank’s excess LCR liquidity; that is:
Notice that short-term borrowing cannot help a bank meet its LCR requirement. If a bank borrows $1 million overnight, for example, its stock of HQLA increases by $1 million. At the same time, however, it also has a new cash outflow of $1 million on the following day, leaving its excess LCR liquidity as defined above unchanged. Short-term lending also does not change a bank’s excess LCR liquidity because a loan made today reduces HQLA but also generates a future cash inflow that lowers NCOF by the same amount (Note: The LCR rules place some restrictions on the degree to which a bank can use anticipated inflows to offset outflows in the NCOF calculation. For the purposes of the discussion here, we assume these restrictions are not binding).
The process of implementing monetary policy relies on changes in the federal funds rate being reliably transmitted through financial markets to these longer-term rates.
By contrast, when a bank borrows or lends at a term that falls outside of the 30-day window, its excess LCR liquidity does change. Borrowing $1 million for at least 31 days, for example, increases the bank’s HQLA by $1 million without any corresponding increase in the NCOF measure. Similarly, when a bank lends at a term of 31 days or longer, its HQLA falls with no corresponding inflow that would reduce the NCOF measure.
The LCR Premium
This discussion shows that for a bank that is concerned about meeting its LCR requirement, term borrowing in the interbank market now brings an extra benefit: it improves a bank’s LCR position. This extra benefit will tend to raise the market interest rate for longer-term loans relative to the overnight rate. We refer to the magnitude of this change as the LCR premium. Specifically, the LCR premium is the increase in the spread between overnight and longer-term (more than 30 days) interest rates created by the new regulation. This premium measures the value of term funding that derives from the fact that this type of borrowing improves the bank’s LCR position.
The size of the LCR premium will depend critically on the total quantity of excess LCR liquidity in the banking system. If the banking system as a whole is facing an LCR shortfall, the LCR premium will be large as banks bid up term interest rates in an attempt to improve their LCR position. If the banking system has an abundance of LCR liquidity, in contrast, banks will find that they are easily meeting the LCR requirement and will seek to lend funds out at term to benefit from the premium. Collectively, these efforts will drive the term interest rate down until the LCR premium disappears.
Importantly, the quantity of excess LCR liquidity is determined by a wide range of factors outside the control of the central bank. For example, a flight-to-quality episode will tend to reduce the supply of government bonds and other HQLA available to the banking system and thus increase the LCR premium. There is still a clear sense in which the central bank can move all market interest rates up and down, of course. However, the LCR premium acts as a new wedge in the monetary policy transmission mechanism. If the central bank keeps the overnight interest rate close to a fixed target, changes in the LCR premium will create changes in term interest rates that are disconnected from the monetary policy stance. Given that the LCR premium will depend on a wide variety of factors, it seems possible that the size of this wedge could be large in some situations and could vary substantially over time.
A Passive Response
How should a central bank react when this new LCR premium appears in market interest rates? One option would be to adjust the central bank’s target for the overnight interest rate accordingly. For example, if a sharp increase in the LCR premium leads to higher term interest rates and tighter financial conditions than the central bank views as appropriate, it could lower its target for the overnight interest rate to mitigate or offset the increase in term rates. This passive approach mirrors the way a central bank typically reacts to changes in other spreads in financial markets. If broad financial conditions tighten for whatever reason, a central bank will often lower its target interest rate as a way of mitigating the effects of this tightening. In this sense, the passive approach appears to be a natural extension of current practice.
A central bank may want to redesign its monetary policy operations with the aim of actively managing the LCR premium.
However, we see three potential problems with this approach. First, if the LCR premium is variable over time, it may require the central bank to make frequent changes in its announced target for the overnight interest rate. Such frequent changes may make it more difficult for the central bank to effectively communicate its intended stance on monetary policy. Second, if the LCR premium is large at times, it will make the economy more likely to hit the zero lower bound on interest rates (or the “effective” lower bound if interest rates are allowed to become slightly negative) in the future. As a result, we could see more frequent instances in which the central bank’s ability to use conventional monetary policy is impaired.
The third potential problem is that a large LCR premium may lead to increased liquidity risk at financial institutions not subject to the regulation. The LCR requirement does not apply, for example, to banks below a certain size or to non-bank institutions. Suppose such an institution borrows funds overnight from a subject bank and lends the same funds back for a 31-day term. The combined effect of these trades would be to increase the excess LCR liquidity of the subject bank by generating a cash inflow on the following day together with a cash outflow that lies outside of the 30-day window (Note: The term loan could be structured with an “evergreen” clause, so that the maturity automatically resets to 31 days every morning and, hence, remains outside of the window for the LCR calculation until either party takes action to prevent the renewal). The arrangement reduces the excess LCR liquidity of the other institution by the same amount, but that fact is of little concern because the institution is not subject to the requirement. When the LCR premium is large, this type of arrangement could generate substantial gain for both parties.
The LCR rules place some limits on subject banks’ ability to use this type of arrangement, but the total scope for this type of activity to increase subject banks’ excess LCR liquidity may nevertheless be substantial. If so, these arrangements would imply that the LCR requirement is not reducing the amount of very-short-term financing in the financial system but is instead encouraging this activity to move outside of the LCR-regulated banking system.
More “Active” Response Options
Given these concerns, a central bank may want to redesign its monetary policy operations with the aim of actively managing the LCR premium. Possible active approaches include:
1. The central bank could conduct open market operations against non-HQLA assets.
When the central bank purchases assets that do not fully count as HQLA in banks’ LCR calculations and pays for this purchase with newly created reserves, it increases the stock of HQLA available in the financial system. This increased stock of HQLA will tend to increase banks’ excess LCR liquidity and, therefore, lower the equilibrium value of the LCR premium. Selling non-HQLA assets will have the opposite effect, making excess LCR liquidity scarcer and raising the equilibrium value of the LCR premium. A similar effect could be achieved with temporary open market operations structured as repurchase agreements using non-HQLA assets, as long as the term is greater than 30 days so that the return leg falls outside of the LCR window. The European Central Bank’s Long-Term Refinancing Operations are an example of what this type of operation might look like in practice.
2. The central bank could offer term loans to banks against non-HQLA collateral.
By offering loans of reserves with a term of longer than 30 days and accepting collateral that is not part of a bank’s stock of HQLA, the central bank can increase banks’ holdings of HQLA without creating a corresponding increase in net cash outflows. The Federal Reserve’s Term Auction Facility, which operated from 2007 to 2010, might be a useful model for this option. In the U.S., where open market operations are conducted with primary dealers rather than banks as counterparties, directly lending to banks may be a more powerful tool as the excess LCR liquidity created by the operation will accrue directly to the borrowing bank.
Notice, however, that these first two options each would also affect the quantity of bank reserves. When the central bank offers term loans to banks in an effort to reduce the LCR premium, for example, the newly created reserves may tend to push the overnight interest rate below the central bank’s target value. In general, a central bank’s efforts to influence the LCR premium using these tools could create an intricate interdependence between term and overnight interest rates that makes implementing monetary policy more difficult (Note: For a detailed analysis of this issue, see Bech and Keister 2017).
To avoid these problems, a central bank may want to find ways to influence the amount of excess LCR liquidity in the banking system without at the same time changing the quantity of reserves. One possibility follows.
3. The central bank could operate a term bond-lending facility.
When banks face a shortage of LCR liquidity and the LCR premium increases, the central bank could offer to lend government bonds or some other highly liquid asset (other than reserves) from its balance sheet to banks against non-HQLA collateral. Doing so would directly increase the amount of HQLA, and hence of excess LCR liquidity, in the banking system without affecting the quantity of reserves. If the central bank wanted to be able to increase the LCR premium, it would need to have a stock of these loans in place in normal times, regularly rolling over, so that it could reduce that quantity when the LCR premium falls below the desired level. The Federal Reserve’s Term Securities Lending Facility, which operated from 2008 to 2010, and the Bank of England’s Discount Window, which allows banks to borrow gilts against less liquid collateral, are possible models for this type of facility.
Four Important Questions
Our discussion so far has focused on the feasibility of structuring a central bank’s operations to directly influence the size of the LCR premium. Viewed from a narrow perspective, taking steps to control this premium seems useful and perhaps essential for effectively implementing monetary policy. Such control may also be important for limiting the incentive for very short-term funding to migrate outside of the regulated banking system. Viewed more broadly, however, such steps raise some important questions that would need to be answered before a central bank could confidently adopt an active approach to managing the LCR premium.
To what extent does having the central bank ‘produce’ excess LCR liquidity through these types of operations counter the original goals of the Basel III liquidity regulations?
The first and perhaps most obvious question is: For what level of premium should the central bank aim? The LCR premium should presumably be positive, as this would give banks an incentive to raise their LCR by other means, including directly holding more HQLA. However, the desired value of the premium should not be so large as to limit the effectiveness of monetary policy or create strong incentives for undesirable regulatory arbitrage. How can policymakers identify a level for the LCR premium that strikes an appropriate balance between these competing concerns?
A second important question is: What non-HQLA assets should the central bank accept in its operations? The choice of what assets to accept will affect market prices and thus potentially affect the allocation of credit in the economy. Prior to the recent financial crisis, the Federal Reserve operated under a policy commonly referred to as “Treasuries-only” in large part to avoid making decisions that directly affect credit allocation. Taking an active approach to managing the LCR premium would require the central bank to move away from such a policy and therefore face the difficult question of what non-HQLA assets to treat favorably.
Third, what size of operations will be needed to effectively control the LCR premium? Central banks had a fairly precise understanding of how the size of an operation affected market interest rates in the pre-crisis period. Moreover, the operations needed to implement monetary policy in that period were generally small compared with the overall size of the central bank’s balance sheet. If the central bank chooses to use the type of operations discussed here to influence the LCR premium, there will be more uncertainty about how large an operation is needed to achieve the desired effect. Precisely how large they would need to be and whether a central bank would be willing to undertake operations of the required size are important open questions.
The final question is the most difficult and perhaps the most important. To what extent does having the central bank “produce” excess LCR liquidity through these types of operations counter the original goals of the Basel III liquidity regulations? Is an outcome in which banks hold HQLA borrowed from the central bank desirable relative to one in which banks own these assets outright? If not, how should policymakers balance the desire to implement monetary policy effectively against these concerns?
As with all new regulations, the Basel III liquidity standards might have unintended consequences and can create new challenges. While some of these consequences may be difficult to foresee, others can be at least partially anticipated. The LCR seems likely to have spillover effects onto the process by which central banks implement monetary policy in short-term money markets. These effects may not be apparent for some time because the requirement is being phased in gradually and also because of the extraordinarily high levels of reserves created by central banks in recent years. When the stance of policy begins to normalize and the size of their balance sheets moves closer to historical norms, however, central banks may face periods when the LCR premium becomes a significant factor in central banks’ ability to implement monetary policy in short-term money markets. It seems prudent, therefore, to begin planning for such periods and to ask how central banks might change their operational procedures to maintain effective control over interest rates.