Summary:
The painful lessons of the 2008 financial crisis illustrate that relying solely on capital regulation does not guarantee that commercial banks will be sufficiently resilient. In this regard, the Basel Committee on Banking Supervision (BCBS) put forward a global liquidity regulatory framework as an important part of Basel Ⅲ. Specifically, BCBS strengthened its liquidity framework by developing two minimum standards for funding and liquidity: the liquidity coverage ratio (LCR), which emphasizes short-term liquidity and the ability to prevent fire sales; and the net stable funding ratio (NSFR), which is aimed at reducing funding risk. Once brought forth, liquidity regulation has raised a fierce debate about its potential impact on commercial banks and the transmission of monetary policy. Although the theoretical banking literature provides a logical framework for liquidity regulation design, no research yet empirically reveals its potential impact, especially the impact of the LCR regulatory requirement. How did commercial banks respond to the LCR regulatory requirement？ Does the LCR regulatory requirement affect the transmission efficiency of monetary policy？ If so, how can we coordinate liquidity regulatory rules and monetary policy？ To the best of our knowledge, these questions have not yet been fully addressed. From both theoretical and empirical perspectives, our paper sheds light on the coordination mechanism between liquidity regulation and traditional monetary policy tools under a macroprudential regulatory framework. Our paper theoretically redefines the liquidity shortage cost function based on the LCR regulatory requirement and incorporates it into a classical Monti-Klein model to illustrate the potential impact of the LCR regulatory requirement on monetary policy transmission efficiency. Our model indicates that the existence of liquidity shortage costs is an essential prerequisite for the monetary policy transmission process. Thus, the LCR regulatory requirement may influence the efficiency of monetary policy transmission by changing the marginal cost of a liquidity shortage. However, this effect depends on commercial banks' liquidity management behavior. Using a semi-annual sample of 65 major commercial banks in China between 2015 and 2019, we empirically test our theoretical predictions. The results show that liquidity regulation has a significant impact on the efficiency of monetary policy transmission, which depends on banks' liquidity management behaviors when facing a possible LCR shortfall. To be specific, commercial banks, which actively adjust their funding structures and strengthen the quality of their liabilities, not only enhance their short-term liquidity profiles, but also improve the efficiency of monetary policy transmission. However, some urban and rural commercial banks with lower LCRs tend to hoard liquidity assets to fulfill LCR requirements, which may reduce the efficiency of monetary policy transmission. Based on the aforementioned findings, this paper features some policy implications. We suggest that regulators should objectively evaluate the potential impact of liquidity regulation on monetary policy transmission efficiency, closely monitor commercial banks' liquidity management behaviors, and flexibly introduce a variety of regulatory settings to ensure banks' resilience and stability and improve monetary policy transmission efficiency. We also recommend that commercial bank managers should properly adjust the structure of assets and liabilities to cope with the potential impact of LCR regulatory requirements. The main contributions of this paper are as follows. First, we expand the application range of the Monti-Klein model and reveal the micro mechanism of monetary policy transmission. Second, we provide empirical evidence for the potential impact of the LCR regulatory requirement, which compensates for the current gap in the liquidity regulation research. Third, we reveal the nexus between liquidity regulation and monetary policy transmission with both a theoretical framework and empirical evidence, which may help future researchers understand the potential impact of the liquidity regulation specifically and macroprudential policy generally. However, this paper is subject to some limitations in terms of data quality and the length of the sample time period. How the LCR affects the interbank market and other monetary policy transmission channels are important questions that require further exploration. For future research in this area, we hope to describe the behaviors of commercial banks more accurately under multiple regulatory constraints, which may enhance the micro-mechanism design of two-pillar policy coordination in China.
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