The Reserve Bank NZ, just released a paper “A macroprudential stable funding requirement and monetary policy in a small open economy” which considers the impact of the Basel III net stable funding requirement, scheduled for adoption in 2018, requires banks to use a minimum share of long-term wholesale funding and deposits to fund their assets.
Central banks act as lenders of last resort to prevent liquidity pressures from becoming solvency problems. Liquidity provision by central banks, however, can lead to the problem of moral hazard. The availability of public liquidity reduces the incentive for banks to raise relatively expensive ‘stable’ funding such as retail deposits and long-term bonds, and leads banks to underinsure against refinancing risk. In periods when credit has grown rapidly, retail deposits have tended to grow more slowly, and banks have shifted toward less stable funding from short-term wholesale markets. The shift toward short- term wholesale funding increases the exposure of the banking system to refinancing risk, both by increasing rollover requirements and by lengthening intermediation chains through funding from other financial institutions. In response to the systemic liquidity stress experienced during the recent global financial crisis, extensive liquidity support was provided to banks, reinforcing incentives for moral hazard. Hence, stronger liquidity regulation has been proposed to increase banks’ self-insurance against liquidity risk.
The Basel III net stable funding requirement, scheduled for adoption in 2018, requires banks to use a minimum share of stable funding, in the form of long-term wholesale funding and deposits, to fund their assets. We introduce a stable funding requirement (SFR) into a small open economy model featuring a banking sector with richly-specified liabilities; deposits as well as short-term and long-term bonds. The SFR regulates the proportion of loans financed by the ‘stable’ component of the bank’s liabilities. The model is estimated for New Zealand, where a similar policy, the Core Funding Requirement, was adopted in 2010. A distinctive feature of the model is that it allows banks to issue short-term and long-term home currency-denominated debt overseas, in order to make loans in the small open economy.
We evaluate how the presence of the SFR alters monetary policy trade-offs between the volatility in inflation, and volatility in other variables such as output, interest rates and exchange rates. A higher SFR raises the share of long term foreign bonds on the banks’ balance-sheet and hence increases the economy’s exposure to shocks to the interest rate spread on long-term foreign debt. This in turn leads to macroeconomic volatility and hence worsens monetary policy trade-offs. However, since the SFR mainly affects the composition of bank funding rather than the cost, the SFR does not affect the transmission of other macroeconomic disturbances that do not affect the bank funding spread. Since bank funding spread disturbances have a negligible influence on the business cycle, the operation of monetary policy is little changed in the presence of the SFR. The additional macroeconomic volatility generated by the presence of the SFR can be diminished and monetary policy trade-offs can be improved if: (i) the central bank raises the interest rate to react systematically to increases in measures of credit growth in the economy and (ii) the SFR policy is varied over time to respond to credit growth.
