The Bank for International Settlement

Abstract

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 extend a standard model of monetary policy implementation in a corridor system to include term funding and an LCR requirement. When banks face the possibility of an LCR shortfall, we show that 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. These results suggest that central banks may want to adjust their operational frameworks as the new regulation is implemented.JEL classification: E43, E58, G28