A Dilemma between Liquidity Regulation and Monetary Policy: Some History and Theory

Abstract

AbstractHistory suggests a conflict between current Basel III liquidity ratios and monetary policy, which we call the liquidity regulation dilemma. Although forgotten, liquidity ratios, named “securities‐reserve requirements,” were widely used historically, but for monetary policy (not regulatory) reasons, as central bankers recognized the contractionary effects of these ratios. We build a model rationalizing historical policies: a tighter ratio reduces the quantity of assets that banks can pledge as collateral, thus increasing interest rates. Tighter liquidity regulation paradoxically increases the need for central bank's interventions. Liquidity ratios were also used to keep yields on government bonds low when monetary policy tightened.