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Regulatory Change and Monetary Policy

Shifting money market relationships and reduced arbitrage have raised volatility at times and have led to greater involvement of the Federal Reserve in financial markets.

By Bill Nelson

The Clearing House

What kind of impact have the Basel III post-crisis bank regulations had on monetary policy? That’s the question that a working group formed by the Committee on the Global Financial System and the Market Committee at the Bank for International Settlements (BIS) tried to answer three years ago. The workgroup consisted of experts from more than 20 central banks and from the BIS. I co-chaired the group along with Ulrich Bindseill of the European Central Bank. At the conclusion of the assessment, in May 2015, the working group released a report, “Regulatory Change and Monetary Policy.” Four years on, this article reviews the conclusions of the group, particularly as they apply in the United States.


The working group focused primarily on three regulations: the leverage ratio, the liquidity coverage ratio (LCR), and the net stable funding ratio (NSFR) (Note: The workgroup also considered large exposure requirements but assessed their likely impact to be limited). The leverage ratio is a capital requirement calculated as the ratio of capital to assets and certain off–balance sheet exposures without any weighting for risk. The LCR requires banks to hold high-quality liquid assets (HQLA) in an amount at least equal to the banks’ projected net cash outflows over 30 days under stress. The NSFR requires banks to maintain a funding profile likely to preserve the bank’s liquidity over a one-year horizon.


The working group reached five main conclusions:

  1. The financial system will be safer, but the supply of bank credit will be lower.
  2. Asset price relationships will shift, but different regulations have different predicted effects.
  3. Arbitrage across markets will weaken.
  4. Demand for central bank reserves will be more difficult to predict, especially at quarter-end.
  5. There will be more central bank intermediation.

A Safer Financial System, But Less Credit

There is a widespread consensus that U.S. banks are financially sound, which is consistent with the outlook of the working group. In each biannual report on the economy that the Federal Reserve provides to Congress, there is a summary of the risks to the financial system. The most recent report, provided in February 2018, indicates that risks are “moderate” despite some elevated asset prices because of the strength of the banking system. In its annual financial stability report, published in December 2017, the Office of Financial Research concluded that “bank solvency and leverage risks are near their lowest levels since 1990.” The Clearing House’s Bank Conditions Index (see Figure 1), which assesses bank conditions based on information related to bank capital, liquidity, interconnectedness, risk-taking, asset quality, and profitability, demonstrates that banks are close to the safest they’ve been in more than 20 years.


As noted in the Committee on the Global Financial System/Market Committee (CGFS/MC) report (p.35), the resilience of the banking sector makes the Fed’s monetary policy job easier. The Fed indicated in its report (p. 24-25) to Congress that if there is a correction in asset prices, the resilience of the banking system should help cushion the blow to the economy.


The evidence for the workgroup’s tentative conclusion that a reduced supply of bank credit could hold back growth is, well, tentative. Bank credit grew strongly from 2014 through 2016, but it slowed considerably last year. The strong growth appears to reflect a recovery from the sharp decline in credit during the crisis as the debt-to-GDP ratio has risen only to about its long-run trend. Although there are indications that credit remains hard to get for small businesses and households with less-than-perfect credit scores, that lack of credit appears to stem from the way the Fed conducts its stress tests, not from Basel III.


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At the same time, the impact on bank credit of the post-crisis regulatory tightening should be studied further. It is well established that internationally and historically, economic recoveries following financial crises are typically weak and protracted, but there appears to be little research on the possibility that the anemic recoveries are a result of a tightening in regulatory requirements following the crisis. More narrowly, in the early 1990s, when Basel I was implemented after widespread bank failures and a resulting recession, the recovery was anemic as well. It wasn’t until many years later, when Joe Peek and Eric Rosengren published their seminal paper on the impact of bank regulations and the 1990s credit crunch, that economists concluded that the sluggish recovery was due in part to a reduced supply of credit stemming from the regulatory reforms implemented after that crunch. The jury is still out if the same is true this time around.


The report (p.39) also calls out a possibility that is relevant for the current discussion of excluding central bank reserves from the denominator of the leverage ratio. Specifically, the report notes the following:


…quantitative easing can put downward pressure on banks’ leverage ratios and reduce their inclination to absorb large amounts of central bank reserves. In such circumstances, if large parts of the banking sector were to operate at the leverage ratio constraint, the more binding leverage ratio requirements could potentially lead to a reduction in the supply of bank credit, undercutting the objective of the non-conventional measure.


The report goes on to note, however, that another possibility is that a binding leverage ratio could make quantitative easing more, not less, effective in providing economic stimulus because banks would strive harder to shed the reserves, putting greater downward pressure on interest rates.


Asset Price Relationships Will Shift

Central banking consists, for the most part, of setting the central banks’ policy rates in a position that moves market interest rates to levels that achieve a desired macroeconomic objective. The CGFS/MC report concluded that the relationships between policy rates and market rates, and the relationships between market rates and macroeconomic outcomes, will shift in response to the post-crisis regulatory changes. But they concluded the shifts are difficult to predict because different regulations have different, and often contradictory, expected effects. For example, liquidity regulations increase the demand for safe and liquid assets, driving down their yields, while leverage requirements make safe and liquid assets less attractive, driving up their yields.


The working group focused primarily on three regulations: the leverage ratio, the liquidity coverage ratio, and the net stable funding ratio.

As predicted, there have been material changes in the relationships between policy rates and market rates because of the Basel III regulations. Although it is difficult to discern the effects of the regulations on asset prices on most days, in some instances, the consequences are dramatic. In particular, because European banking institutions have their leverage ratios calculated at quarter-end, the requirement is essentially turned on and off on that day (See Figure 2). The report predicted that the leverage ratio would push money market rates and activity down, and that is the effect observed at quarter-ends. Presumably, the effect is also always present and is not just limited to quarter-ends because U.S. banks’ leverage ratios are evaluated on a period-average basis.


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One development that the CGFS/MC did not anticipate is the breakdown, particularly at quarter-end, of the normal pricing relationships connecting foreign exchange rates and money market rates. One of the few “laws” of economics, covered interest parity (CIP), states that it should cost the same to borrow in any two currencies after adjusting for the change in the exchange rate priced into futures markets. For example, it should cost the same to borrow funds in dollars as it does to borrow in yen, buy dollars with the yen in the spot market, and buy the foreign currency needed for repayment of the loan in the futures market.


In recent years, Japanese financial institutions have invested heavily in dollars, funded with yen deposits, and European banks have taken the other side of that position. At each quarter-end, the European banks reduce their participation in the market, and it becomes temporarily very expensive to borrow in dollars relative to yen, violating CIP (see Figure 3).


An unambiguous effect predicted by the report was that the LCR would lower the equilibrium federal funds rate, or r*. The equilibrium federal funds rate is the interest rate above which monetary policy restrains the economy and below which it stimulates the economy. The LCR reduces r* by increasing banks’ demand for short-term assets and borrowings beyond 30 days, and increasing bank supply of short-term loans. A low r* is harmful because it increases the likelihood the Fed will hit the zero lower bound again when the economy enters a recession. As predicted, a recent paper by economists at the New York Fed concluded that a considerable fraction of the observed decline in r* in recent years owed to greater scarcity of liquid assets, caused in part by the LCR.


One potential consequence that the working group did not consider may be a tendency for the LCR to make retail deposits more attractive as a source of funding. As noted above, the liquid asset holdings required under the LCR are based on a projection of net cash outflows under stress. Only a small percentage of retail deposits are assumed to flow out in the projection and so are an attractive source of funding for the purposes of LCR compliance. As a consequence, banks subject to the LCR have an additional incentive to bid aggressively for deposits relative to banks that are not subject to the LCR.


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It is still too soon to determine whether that added incentive will leave an imprint on deposit pricing and distribution. When all interest rates were compressed down to the zero lower bound during the recession, depositors had little incentive to seek higher yields outside the banking sector, and deposits were plentiful. As interest rates rise, deposit rates may stay closer to market rates than they did historically, and deposits could shift toward the larger banks that are subject to the LCR and away from smaller banks.


Arbitrage Across Markets Will Weaken

The CGFS/MC report anticipated that the post-crisis regulations, particularly the leverage ratio requirement, would reduce arbitrage across financial markets. In particular, arbitrage is often facilitated by repo leverage provided by large banking institutions, but the leverage ratio, as well as the proposed NSFR, would make large matched repo books more expensive. Specifically, the report (p.16) states the following:


Overall, these changes will tend to reduce incentives for matched-book repos and similar activities and, hence, may affect the ease and amount of arbitrage across financial markets. This may weaken, and make more uncertain, the links between policy rates and other interest rates, driving wedges between those rates as well as between policy rates and other asset prices relevant for economic activity.


Consistent with the workgroup’s expectation, the correlation between changes in the Federal Open Market Committee’s (FOMC) target for the federal funds rate and the repo rate has fallen noticeably relative to its pre-crisis level. Klee et al. (2016) find that, although changes in the federal funds rate were highly significant predictors of changes in the repo rate before the crisis, after the crisis the significance evaporated, a change the authors attribute in part to the reduction in dealer arbitrage as a consequence of the supplemental leverage ratio requirement.


The evidence for the workgroup’s tentative conclusion that a reduced supply of bank credit could hold back growth is, well, tentative.

As noted, the working group predicts that arbitrage between financial markets will weaken not only because of the leverage ratio requirement but also because of the net stable funding ratio requirement. The NSFR, which has been proposed but yet not adopted in the United States, also makes it more costly for banks to hold matched repo books. As a result, the weakening in the transmission between the federal funds rate and repo rates will likely worsen if the NSFR is adopted.

Volatile Demand for Central Bank Reserves

Because the Federal Reserve is still conducting monetary policy using a floor system, it is difficult to know if the post-crisis regulations have led to more volatile demand for reserves. The report noted that small movements in interest rates could lead to big swings in reserve demand because banks are demanding reserves in part to satisfy their LCR requirements, but that the continued superabundance of reserves makes such developments hard to discern. However, as mentioned earlier, the reductions in demand predicted for quarter-ends are clearly evident, with interbank rates falling sharply. (Note: For a recent discussion of the post-crisis regulations on the demand for reserve balances, see Lorie Logan, “Operational Perspectives on Monetary Policy Implementation: Panel Remarks on ‘The Future of the Central Bank Balance Sheet,’” Remarks at the Policy Conference on Currencies, Capital, and Central Bank Balances, Hoover Institution, Stanford University, Stanford, California, May 4, 2018).


More Central Bank Intermediation

With arbitrage across markets expected to be weaker, reserve demand more volatile, and a number of regulations favoring interactions with the central bank rather than with other market participants, the working group predicted that central banks would intermediate more frequently in financial markets when implementing monetary policy. The prediction is coming true in the United States. For instance, in the press conference after the March FOMC meeting, Chairman Jerome Powell indicated that the FOMC may continue to operate with a floor-based system in part because banks need abundant reserves to satisfy their liquidity requirements (Note: For a discussion of the Fed’s monetary policy framework, see Bill Nelson, “Get up off the Floor: Remarks at Currencies, Capital, and Central Bank Balances: A Policy Conference Panel on the Future of the Central Bank Balance Sheet,” Hoover Institution, Stanford University, Stanford, California, May 4, 2018).


The working group predicts that arbitrage between financial markets will weaken not only because of the leverage ratio requirement but also because of the net stable funding ratio requirement.

The Fed also intervenes more frequently than before the crisis by maintaining a standing overnight reverse repurchase (ONRRP) facility. At the facility, counterparties, primarily money funds and government-sponsored enterprises, provide the Fed dollars in exchange for government securities. That is, the facility is effectively a means for the Fed to circumvent its inability to pay interest to nondepository institutions. While initially announced as only a temporary tool to help the Fed lift interest rates when reserve balances were elevated, the ONRRP now appears to have become a permanent fixture. The facility is intended to improve the Fed’s control of money market rates and, indeed, Klee et al. (2016) note that the introduction of the ONRRP facility improved the transmission of changes in the federal funds rate to other money market rates.



The predictions of the CGFS/MC working group for the likely impact of post-crisis regulations on monetary policy have proven to be relatively accurate. Banks are safe, but at the same time, shifting money market relationships and reduced arbitrage have raised volatility at times and have led to greater involvement of the Federal Reserve in financial markets.


Several consequences remain to be seen. In the medium term, the changes could constrain the choice of monetary policy framework for the FOMC after it shrinks its balance sheet. For one thing, it may be impossible for the Fed to revert to a smaller balance sheet if it needs to continue to provide a very high level of reserve balances so that banks can meet their LCR requirements. More broadly, as the report (p.2) notes:


Weakened incentives for arbitrage and greater difficulty of forecasting the level of reserve balances, for example, may lead central banks to decide to interact with a wider set of counterparties or in a wider set of markets.


Over a hopefully longer horizon, the report also indicates that the Fed may find itself more frequently at the zero lower bound and less able to provide economic stimulus in such circumstances. As discussed above, the LCR will lead to increased demand for safe and liquid assets and therefore a lower level of the equilibrium federal funds rate. With interest rates generally lower, the Fed will more frequently have to reduce the federal funds rate to zero in a recession. If the Fed then turns to asset purchases to provide stimulus, the added reserves will make it more difficult for banks to comply with the leverage ratio requirement (Note: The Bank of England excluded reserve balances from the leverage ratios calculated for U.K. banks in order to eliminate the possibility that compliance with the regulation would reduce the effectiveness of its asset purchases. See Bank of England (2016), Record of financial policy committee meeting held on 25 July 2016). As a result, banks may seek to reduce other assets including by lending less. In sum, Basel III could both make it more likely that central banks will need to turn to extraordinary monetary policy and make that policy less effective.