Summary:
The global financial crisis of 2007–09 revealed substantial weaknesses in large banks' capital adequacy and liquidity. Bank regulators responded with a variety of prudential measures intended to strengthen both. However, these prudential measures resulted in conflicts with the implementation of monetary policy that helped alter the way the Federal Reserve conducts monetary policy. I review three such conflicts: regulation inhibiting interest on excess reserves arbitrage starting in 2008, regulation inhibiting banks' operations in the repo market in 2019, and regulation inhibiting their operations in the Treasury securities market in 2020. The article concludes with a discussion of the issues associated with changing specific banking regulations and some more general suggestions for dealing with these types of conflicts.
Key findings:
- U.S. banking supervision and regulation imposes costs on bank holdings of reserves, U.S. Treasury securities, and repo on Treasuries.
- These costs have reduced bank holdings of excess reserves and their market making in Treasury and repo markets.
- During the last decade, the Federal Reserve has been forced on three separate occasions to adjust the way it conducts monetary policy in part because of the regulatory costs imposed on reserves, Treasuries, and repos.
- The regulatory policies that have had the greatest impact on the implementation of monetary policy could be revised or significantly changed, albeit doing so comes with some other consequences.
Center for Financial Innovation and Stability
JEL classification: E52, E58, G28
Key words: banking regulation, capital adequacy, bank liquidity regulation, interest on reserves, Treasury market, repo market
https://doi.org/10.29338/ph2021-03
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