Does Excluding Reserves from the Leverage Ratio Make Quantitative Easing More Effective? More Yes than No.

When a central bank expands its balance sheet by purchasing securities or making loans, it generates a corresponding increase in bank deposits at the central bank (a/k/a “reserves”).  Those reserves, which are bank assets, cannot be created or destroyed by subsequent transactions between banks or between a bank and a non-bank.  A bank’s leverage ratio is the ratio of its capital to its total assets, without weighting the assets for risks.  Holding capital and all other bank assets equal, an increase in reserves therefore must reduce the leverage ratio of the banking system as a whole, and of each bank that receives them.

If a bank wishes to avoid a decrease in its leverage ratio or a capital raise, it must shed other assets (such as loans to businesses and households). Collectively, if a sufficient number of banks take such action, such a reduction in bank credit could reduce economic activity and reduce or even reverse the economic stimulus intended by the central bank when increasing its balance sheet.  The problem is particularly acute for quantitative easing programs such as those conducted by the Bank of Japan, the Federal Reserve, and the European Central Bank because of the massive amount of reserves created.

Indeed, the Bank of England was sufficiently concerned that pressure on leverage requirements would undercut lending programs through which it was attempting to provide stimulus that it decided to exclude reserves from the denominator of its leverage ratio.  As the BoE explained in its July 2016 financial stability report, “In circumstances where central bank balance sheets expand (for example, through increased use of liquidity facilities), regulatory leverage requirements can effectively tighten.”  Similarly, a 2015 report on the impact of Basel II on monetary policy issued by the BIS’s Committee on the Global Financial System raised concerns that leverage ratio pressures could prevent banks from even participating in central bank operations –

In particular, the question is whether there are exceptional situations in which banks would refrain from subscribing to fund-supplying operations because concerns over the LR impact of the reserves that would be added to the banking system in aggregate outweigh the financial benefits accrued by participating in the operations. If so, this lack of participation could prevent a central bank whose operating framework entailed increasing the quantity of reserves from meeting its operating target.

While these concerns make intuitive sense, in another way they run contrary to the core Neo-Keynesian explanation for how monetary policy works.  As described in Brainard and Tobin (1968) and Tobin (1969), interest rates fall when central banks add reserves because asset prices must adjust to make the banks willing to hold the reserves voluntarily.  In particular, loan rates must fall.  If leverage ratios make banks dislike holding reserves even more, loan rates must fall further.

That said, the Brainard-Tobin and Tobin analysis only consider a situation where central banks do not pay interest on reserve balances.  In the current situation in the United States, the Federal Reserve raises and lowers interest rates by adjusting the interest rate it pays on excess reserves.  The reduction in the ability of the central bank to lower rates considered in this note is only relevant when the central bank has lowered the interest it pays on excess reserves to its lower bound and is seeking to reduce other market interest rates through quantitative easing.

Unless the large majority of banks in the banking system are, in fact, bound by the leverage ratio, then the Brainard-Tobin intuition would seem the dominant one.  As reserves go up, banks are increasingly eager to shed reserves, but in the equilibrium where they hold the reserves voluntarily, the interest rates on other bank assets, including bank loans, must fall by even more than they would without a leverage ratio requirement.  If so, excluding reserves from the leverage ratio could make monetary policy less effective, in terms of the decline in interest rates associated with a given increase in reserves, than it would be if reserves were not excluded.

In this note, we present a simple model of banks, households, and the Fed that we then simulate.  We use simulations to explore how interest rates and balance sheets behave when the Fed increases reserves and banks face balance sheet costs.  To model the impact of a leverage ratio requirement, we simulate a situation in which those costs depend on total bank assets and another in which they depend on total bank assets minus reserves.

Our results indicate that, at least for this stylized model, both intuitions are correct.  In the base case in which reserve balances increase, all interest rates decline and loans decline.  When reserves are excluded from the leverage ratio, both interest rates and loans decline by less. In another case in which loans increase when reserves are added, excluding reserves from the leverage ratio again results in a lesser decline in interest rates, but in this case, loans increase by more.  In general, excluding reserves from the leverage ratio lessens the tendency for QE to reduce credit availability, but it also dampens the interest rate reduction caused by QE.

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