Summary:
With the increasing uncertainty of the international and domestic economic and financial situation, the short-term liquidity supply and demand fluctuations in China's banking system have increased in recent years. Drawing on its international experience, the People's Bank of China has made a series of innovations in using monetary policy tools, such as short-term liquidity operations (SLO), standing lending facilities (SLFs) and medium-term lending facilities (MLFs). Compared with the traditional liquidity management tools, what are the transmission mechanisms and effects of these new liquidity facilities? How should the central bank regulate and use these liquidity facilities? As the related domestic literature focuses either on empirical analysis or else adopts a partial equilibrium analysis framework, it is difficult to identify the transmission effects of such monetary policy tools on the real economy. To solve this problem, this paper constructs an endogenous liquidity demand mechanism for mediating between banks with liquidity shortages and banks with liquidity surpluses. The paper also builds a DSGE model to assess the inter-bank market, and then conducts theoretical and empirical research on the transmission mechanisms and effects of liquidity facilities. First, the paper compares the macroeconomic fluctuations in a frictionless inter-bank market situation with the fluctuations in a frictional inter-bank market situation, and then it analyzes the reasons why the central bank needs to facilitate liquidity intervention through liquidity facilities. In the frictionless inter-bank market, runs only occur in the deposit market, and not in the inter-bank market. However, in the frictionless inter-bank market, runs occur simultaneously in both the deposit and the inter-bank markets. The differences between these two situations reflect the net effects of macroeconomic fluctuations caused by runs on the inter-bank market. When the financial sector suffers a negative impact, the banks with liquidity shortages and banks with liquidity surpluses both increase their preventive demands for liquidity, thereby pushing the inter-bank market's overall demand for liquidity to remain high. Second, this paper considers the case of an enlarged liquidity gap in the inter-bank market and of market failure, in which the process of relying solely on the spontaneous return of the market to a steady state takes too long, and the central bank is required to intervene in support of liquidity. Through modeling the operations of the liquidity facility, this paper finds that on one hand, the central bank can guide loan market pricing by adjusting the interest rates of liquidity facilities, thereby keeping credit spreads within a reasonable range. on the other hand, under uncertain economic conditions, the banks with liquidity surpluses fail to quickly restore the supply of liquidity to the banks with liquidity shortages. In such cases, the central bank can supplement liquidity directly into the market by acting as the lender of last resort, thereby supplying external liquidity to eliminate the gap caused by the insufficient internal liquidity supply in the inter-bank market. Finally, this paper evaluates real quarterly data on China's macroeconomic variables from 2002 to 2018, and it does so on the basis of parameter calibration and Bayesian estimation. This assessment enables a discussion of the theoretical aspects of the inter-bank market liquidity risk contagion mechanism, and the transmission effects of liquidity facilities. The findings indicate that liquidity facilities can guide loan market pricing and keep credit spreads within a reasonable range. At the same time, the central bank's direct liquidity intervention, as the lender of last resort, has a very significant effect. Based on these research conclusions, the following policy suggestions are provided: (1) The central bank should further improve the LPR pricing mechanism, play a guiding role in setting a medium-term lending facility interest rate, and promote the reduction of financing costs in the real economy. (2) Liquidity facilities are of great significance in reducing the liquidity risk of the inter-bank market, and in weakening macroeconomic fluctuations due to negative shocks. However, it should not be assumed that these monetary policy tools are omnipotent. (3) The central bank should further improve the collateral framework, expand the scope of collateral to ensure the safety of central bank assets, and enhance the availability of central bank funds to financial institutions. (4) The liquidity supply from lending facility operations should be linked with commercial bank credit, thereby establishing an incentive compatibility mechanism. Such a mechanism can guide funds for investment in key areas of the national economy, and help to promote the optimization and upgrading of the economic structure.
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