Abstract
Abstract Inspired by the extensive criticisms against the textbook fractional reserve theory, this paper revisits the mechanics of money creation process and complements the traditional focus on the reserve requirement by elaborating on the roles of three prudential regulations proposed in the Basel III accord. In particular, the authors consider such conditions where the financial markets are imperfect and suffer from various frictions that the commercial bank cannot readily modulate their liquidity and capital buffers, especially at an aggregate level or within a short period. Meanwhile, as a result of maturity mismatch and fundamental uncertainty, the credit and money creation activities inevitably add to the liquidity and insolvency risks faced by the bank. Under the assumptions that the levels of bank reserves, capital and government bonds are exogenously given, and that the concerned prudential regulations are always binding, the authors examine the determinants of the broad money aggregate and the money multiplier. Specifically, they find that 1) the money multiplier under Basel III is not constant but a decreasing function of the monetary base; 2) the determinants of the bank’s money creation capacity are regulation specific; 3) when multiple regulations are imposed simultaneously, the effective binding regulation and the corresponding money multiplier will vary across different economic states and bank balance sheet conditions.
Highlights
Since the financial crisis in September 2008, central banks have greatly expanded the scope of its tools to stimulate economies by cutting interest rates to the zero lower bound and taking on unconventional measures such as “quantitative easing” (QE)
We find that 1) when the banking system is constrained by any of the three prudential regulations, the money multiplier responds negatively to the increase of the monetary base, which is different from the constant money multiplier when the bank is only constrained by the reserve requirement; 2) raising the monetary base may not boost the broad money supply when the Leverage Ratio (LR) regulation acts as the binding constraint; 3) the determinants of the money supply and the money multiplier are specific to the binding regulation by which the bank is constrained
This paper is inspired by pioneering works on rethinking the roles of the banking system in money creation
Summary
Since the financial crisis in September 2008, central banks have greatly expanded the scope of its tools to stimulate economies by cutting interest rates to the zero lower bound and taking on unconventional measures such as “quantitative easing” (QE). As shown, the actual liquidity coverage ratio, risk-based capital adequacy ratio and leverage ratio usually decrease along with the increases in loans and deposits When these ratios reach or come close to the minimum requirements of the Basel III accord, banks will become more cautious in making loans due to the high cost of regulation violation.. Given the minimum requirement of the concerned prudential regulations and the current level of the bank’s credit base and risk conditions of its asset and liability, we can derive a maximum limit for the loans and deposits that can be created by the bank
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