Monday, 16 January 2012

Interest on reserves as a policy tool for financial stability

Tim Taylor has another terrific post, today on a Stein paper on interest on reserves.  here's the point.

1. banks have to sell equity as a cushion against asset price declines.
2. banks also have to hold reserves with the Central Bank, also as a potential cushion against trouble.
3. some central banks pay interest on those reserves, some do not.
4. the usual Central Bank policy lever is to via open market operations, buying and selling bonds from banks (and thus affecting short term interest rates), providing thus banks with more or less cash from which they then lend more or less out.
5.  making banks hold reserves provides another policy lever.  And now that Central Banks want to conrol both financial stability as well as short interest rates, they need another lever. 
6. So how do they do it?  Taylor writes:

"During the financial crisis, banks and other financial institutions found themselves in trouble because they had all ramped up their level of short-term debt--that is, debt which came due quite soon on a daily or monthly basis and was commonly being rolled over (and over and over) each time it came due. When the financial crisis hit, it became impossible to roll over all this short-term debt, and so many financial institutions suddenly found themselves without funding.

Kashyap and Stein argue that financial institutions will often have a tendency to take on too much short-term debt from society's point of view, because individual financial institutions are looking only at their own finances and not taking into account the risk that if they all take on too much short-term debt, the risk of a system-wide financial crisis goes up. Thus, a way to reduce the risk of financial crisis is to put limits on bank holdings of such short-term debt.

One way to do this is to use a broad notion of "reserve requirements." In theory, banks wouldn't just hold reserves based on the deposits from customers, but on any debt that they are depending on renewing in the short run. Kashyap and Stein explain: "

...within the traditional banking sector, reserve requirements should in principle apply to any form of short-term debt that is capable of creating run-like dynamics, and hence
systemic fragility. This would include commercial paper, repo finance, brokered certificates of deposit, and so forth.

...Going further, given that essentially the same maturity-transformation activities take place in the shadow banking sector, it would also be desirable to regulate the shadow-banking sector in a symmetric fashion."

so, a new instrument to regulate both intereset rates and the cushion of reserves that banks must hold.  and a new way of thinking about monetary policy.