Money markets play a central role in monetary policy implementation. Money market functioning has changed since the financial crisis. This arguably reflects the interaction of two forces: Changes in monetary policy, and changes in regulation. This interaction is not yet well understood. We focus on the newly introduced Liquidity Coverage Ratio (LCR) and how it influences the behaviour of banks and the equilibrium on the money market. We develop a theoretical model to analyse how liquidity regulation may interfere with the central banks implementation of monetary policy. We find that when the market equilibrium is suboptimal due to asymmetric information, both the central bank and the regulator can act to improve welfare. These actions can be complementary or conflicting, depending on the environment. The main insight from the central bank perspective is that the regulator can reach the welfare optimum, but at the expense of the central bank moving away from its optimum. The central bank will thus need to adjust its implementation of monetary policy accordingly, to address the effects of liquidity regulation.
Keywords: regulation; Basel III; central bank; interbank lending; money market; asymmetric information.
JEL classifications: E43; E58; G01; H12; L51.
Working paper no. 596