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As part of the regulatory response to the recent global financial crisis, the Basel Committee on Banking Supervision (BCBS) announced a new international regulatory framework for banks, known as Basel III. One important component of Basel III is the Liquidity Coverage Ratio (LCR), which aims to ensure that banks hold a more liquid portfolio of assets and rely on the central bank for funding only as a last resort. Specifically, the LCR requires each bank to hold a sufficient quantity of highly liquid assets to survive a 30-day period of market stress; this requirement is scheduled to be phased in gradually beginning in January 2015.
In the process of designing and calibrating the LCR rules, it became clear that some jurisdictions do not have sufficient high-quality liquid assets (HQLA) for their banking system to meet this new requirement. Australia and South Africa are cases in point, as both have limited amounts of sovereign debt and other qualifying securities; see Debelle (2011), Heath and Manning (2012) and South African Reserve Bank (2012). In such jurisdictions, the regulation offers the central bank the option of providing, for an up-front fee, contractual committed liquidity lines that count toward a bank’s stock of liquid assets. Stein (2013) argues that such lines have the potential to be a useful safety valve in other situations as well, since they can place an upper bound on the cost of the liquidity regulation.
This type of committed liquidity facility (CLF) is an innovation within central banking and raises several interesting questions. How should these facilities be designed and priced? How will they interact with other parts of central banks’ missions? Should such facilities be used only in jurisdictions with a shortage of HQLA or should they be part of all central banks’ toolkits? With a view to providing a framework for addressing these questions, authors develop a model that extends their earlier work on implementing monetary policy in the presence of an LCR requirement (Bech and Keister 2013). Authors show how the LCR requirement can have significant side effects in a jurisdiction with a limited supply of HQLA, leading to a large regulatory liquidity premium and pushing the short-term interest rate to the floor of the central bank’s rate corridor. Introducing a CLF allows the central bank to mitigate these effects, regardless of whether it is implemented as a fixed-price standing facility or using a fixed-quantity auction format. By pricing the CLF appropriately, the central bank can control either the equilibrium liquidity premium or the quantity of liquid assets held by banks, but not both. Authors argue that the optimal pricing arrangement will need to balance the costs of higher interest rate spreads against the benefits of having more liquid assets in the banking system and will depend on local bond market conditions. Moreover, given the uncertainty about equilibrium relationships in the new regulatory environment, authors argue that central banks are likely to want to take a flexible approach to CLF pricing, adjusting terms as more experience is gained with this new policy tool.
The authors provide a brief overview of the new regulatory framework in the next Section, then present their model in Section 3. They derive banks’ demand for assets and CLF drawing rights in Section 4 and study equilibrium quantities and interest rates in Section 5. Authors use the model to discuss CLF pricing and related issues in Section 6 before concluding in Section 7.