The impact of the liquidity coverage ratio on money creation: A stock-flow based dynamic approach

Abstract

This paper examines money creation process of the banking system when it is complying with the Liquidity Coverage Ratio (LCR). A stock-flow based dynamic model of credit creation process is developed in which the commercial bank supplies loans to the firm. The change of credit is governed by the bank lending and the repayment of the existing loans, where the equilibrium stock of credit could be attained once the lending is exactly equal to the repayment. However, the supply of bank loans is restricted by both the reserve requirement set by the central bank and the LCR prescribed by the banking authority; and, as a result, money creation must be affected by all these regulations. The bank loan supply under the constraint of the required liquidity buffer might have different prescriptions under different economic scenarios, and would eventually result in an equilibrium monetary stock correspondingly. The final formula of money multiplier is derived respectively as the rational response of the bank to the corresponding regulation. When the reserve requirement is tighter than the LCR, the money multiplier has the same expression of that in the prevailing fractional reserve regime. Yet when the situation departs from this regime, the determinants of the money multiplier are found to be associated with the parameters that characterize the behavior of banks subject to the regulation and of the private sector rather than those monetary structural factors. It is noteworthy that there may be a credit contraction and even a significant reduction in money multiplier when the bank is regulated by the LCR. This novel perspective on credit creation of the banking system also offers us an insightful understanding on the impacts of banking regulations on the stability of the banking system and suggests a new guide tool for designing them.