A bit of a Curate's Egg: Liquidity Regulation and Bank default risk [JOB MARKET PAPER] [PDF]
Abstract: This paper examines the impact of liquidity regulation on bank default risk using a historical setting in India between 1971 and 2002, when the Statutory Liquidity Ratio (SLR) functioned as the sole prudential tool. Leveraging a novel bank-level dataset and an instrumental variables strategy based on exogenous government borrowing projections, I identify the causal effect of SLR changes on bank solvency. The results show that higher liquidity requirements significantly increase long-run default risk, with Z-scores declining by approximately 28 percent over five years. This effect is primarily driven by profitability losses, as banks are required to hold low-yielding liquid assets while maintaining competitive deposit rates, leading to a persistent negative carry. However, the impact of SLR shocks varies across banks. Undercapitalized banks experience a more muted deterioration in default risk relative to bettercapitalized peers. These differences emerge primarily from greater deleveraging by undercapitalized banks, combined with increased reliance on wholesale funding and a reallocation away from longer-term lending to reduce maturity mismatches. These findings highlight the trade-offs inherent in liquidity regulation and underscore how capital adequacy and profitability jointly shape its effects on bank stability.
Streams beneath the surface: The Macroeconomic Effects of Liquidity Regulation [PDF]
Abstract: This paper investigates the macroeconomic effects of liquidity regulation by studying changes in India’s Statutory Liquidity Ratio (SLR) between 1951 and 2023. Using a narrative identification strategy to isolate exogenous policy shifts, combined with a local projections framework estimated via instrumental variables, I examine the dynamic effects of SLR changes on key macroeconomic and financial variables. The results indicate that increases in the SLR lead to a significant contraction in real GDP in the medium run, alongside persistent inflationary pressures and a tightening of monetary and credit conditions. These effects are asymmetric: tightening actions produce strong and persistent macro-financial responses, while loosening actions yield muted effects. I identify two main transmission channels—portfolio reallocation on the asset side, with a shift from long-term to short-term lending, and adjustments in funding structure, including increased reliance on deposit mobilization and reduced use of money market borrowings. These findings provide fresh insights into the real effects of liquidity regulation, a dimension that remains relatively underexplored compared to its regulatory counterparts such as capital requirements.
The more, the worse: Central Bank Balance sheet policies and Excess Liquidity in Sub-Saharan Africa
(with Melesse M. Tashu and Charalambos G. Tsangarides, IMF)
Abstract: The persistence of excess liquidity in Sub-Saharan Africa (SSA) poses significant challenges for effective monetary policy transmission. While conventional explanations emphasize precautionary motives and the opportunity cost of holding reserves, this paper highlights the importance of an involuntary component driven by central bank balance sheet policies. Using a novel supply-side approach, we exploit variation in autonomous liquidity factors—specifically changes in net foreign assets (NFA) and net credit to government (NCG)—to identify reserve supply shocks. Employing a panel local projections framework across 36 SSA countries, we find that both NFA and NCG shocks significantly raise excess liquidity, with effects from NFA being more persistent. Forecast error variance decompositions show that these shocks account for an average of 21 percent of the variation in excess liquidity. The magnitude of responses varies across countries and is amplified in resource-rich economies with rigid exchange rate regimes and weak sterilization practices. In contrast, countries with stronger institutional settings—such as fiscal rules, central bank independence, transparency, and reliance on market-based liquidity tools—exhibit muted liquidity responses. We also show that reserve supply shocks increase short-term interest rate volatility, particularly where payment systems are inefficient. These findings underscore the importance of institutional reforms to enhance liquidity management and policy effectiveness in SSA.