Required reserves as a credit policy tool

Abstract

This paper conducts a quantitative investigation of the role of reserve requirements as a macroprudential policy tool. We build a monetary DSGE model with a banking sector in which (i) an agency problem between households and banks leads to endogenous capital constraints for banks in obtaining funds from households, (ii) banks are subject to time-varying reserve requirements that countercyclically respond to expected credit growth, (iii) households face cash-in-advance constraints, requiring them to hold real balances, and (iv) standard productivity and money growth shocks are two sources of aggregate uncertainty. We calibrate the model to the Turkish economy which is representative of using reserve requirements as a macroprudential policy tool recently. We also consider the impact of financial shocks that affect the net worth of financial intermediaries. We find that (i) the time-varying required reserve ratio rule countervails the negative effects of the financial accelerator mechanism triggered by adverse macroeconomic and financial shocks, (ii) in response to TFP and money growth shocks, countercyclical reserves policy reduces the volatilities of key real macroeconomic and financial variables compared to fixed reserves policy over the business cycle, and (iii) a time-varying reserve requirement policy is welfare superior to a fixed reserve requirement policy. The credit policy is most effective when the economy is hit by a financial shock. Time-varying required reserves policy reduces the intertemporal distortions created by the credit spreads at expense of generating higher inflation volatility, indicating an interesting trade-off between price stability and financial stability.

Capital controls as a credit policy tool in a small open economy

“…Our findings suggest that capital controls can play an alternative role to the direct credit policy in mitigating the contraction after a crisis. Our study is in line with Mimir et al (2013) that examine the possibility of reserve requirements as a credit policy tool.…”

“…We then consider a shock that tightens the balance sheet constraint and show that capital controls may alleviate the negative effect due to the balance sheet shock as much as a direct credit policy does. Our study is in line with Mimir et al (2013) that investigate the role of reserve requirements as a credit policy tool. Mimir et al (2013) show that a time-varying reserve requirement policy mitigates the fluctuations in key macroeconomic variables in response to macroeconomic and financial shocks.…”

“…Our study is in line with Mimir et al (2013) that investigate the role of reserve requirements as a credit policy tool. Mimir et al (2013) show that a time-varying reserve requirement policy mitigates the fluctuations in key macroeconomic variables in response to macroeconomic and financial shocks. In contrast, our paper shows that capital controls, the effects of which are rigorously examined as a policy tool for emerging economies, can be a credit policy tool to mitigate crisis shocks.…”

“…Whereas Mimir et al (2013) show that reserve requirement policy can mitigate the economy's fluctuations in response to financial shocks, our paper shows that capital controls, the effects of which are rigorously examined as a policy tool for emerging economies, also can be a credit policy tool.…”

Reserve Requirements and Loan Loss Provisions as Countercyclical Macroprudential Instruments: A Perspective from Latin America

“…As discussed by Robitaille (2011), in Brazil, despite the country's high reserve ratios, reserve requirements have been seen as an important tool for managing liquidity risk. See also Mimir, Sunel and Taskin (2012) for Turkey. 18 Ahmed and Zlate (2014) provided evidence that interest rate differentials and global risk aversion are important determinants of net private capital inflows to middle-income countries, especially (for portfolio flows) in the aftermath of the global financial crisis.…”