The liquidity coverage ratio and monetary policy implementation

In addition to revamping existing rules for bank capital, Basel III introduces a new global framework for liquidity regulation. One part of this framework is the liquidity coverage ratio (LCR), which requires banks to hold sufficient high-quality liquid assets to survive a 30-day period of market stress. As monetary policy typically involves targeting the interest rate on loans of one of these assets — central bank reserves — it is important to understand how this regulation may impact the efficacy of central banks’ current operational frameworks. We introduce term funding and an LCR requirement into an otherwise standard model of monetary policy implementation. We show that when banks face the possibility of an LCR shortfall, it becomes more challenging for a central bank to control the overnight interest rate and that the very short end of the yield curve becomes steeper. Our results suggest that central banks may want to adjust their operational frameworks as the new regulation is implemented. JEL classification: E43, E52, E58, G28.