DP 2016 / 04 A macroprudential stable funding requirement and monetary policy in a small open economy

The Basel III net stable funding requirement, scheduled for adoption in 2018, requires banks to use a minimum share of long-term wholesale funding and deposits to fund their assets. This paper introduces a stable funding requirement (SFR) into a small open economy DSGE model featuring a banking sector with richly-specified liabilities. We estimate the model for New Zealand, where a similar requirement was adopted in 2010, and evaluate the implications of an SFR for monetary policy trade-offs. Altering the steady-state SFR does not materially affect the transmission of most structural shocks to the real economy and hence has little effect on the optimised monetary policy rules. However, a higher steady-state SFR level amplifies the effects of bank funding shocks, adding to macroeconomic volatility and worsening monetary policy trade-offs conditional on these shocks. We find that this volatility can be moderated if optimal monetary or prudential policy responds to credit growth. ∗ The Reserve Bank of New Zealand’s discussion paper series is externally refereed. The views expressed in this paper are those of the author(s) and do not necessarily reflect the views of the Reserve Bank of New Zealand. We thank an anonymous referee, Glenn Otto, Massimiliano Pisani, Christie Smith, Lenno Uusküla, Benjamin Wong, conference participants at the Melbourne Institute Macroeconomic Policy Meeting 2015 and the Central Bank Macroeconomic Modelling Workshop 2015, and seminar participants at the Bank of Estonia and the Bank for International Settlements for helpful suggestions. † Punnoose Jacob: Economics Department, Reserve Bank of New Zealand, 2 The Terrace, PO Box 2498, Wellington, New Zealand. Email: Punnoose.Jacob@rbnz.govt. nz. Anella Munro: Economics Department, Reserve Bank of New Zealand, 2 The Terrace, PO Box 2498, Wellington, New Zealand. Email: Anella.Munro@rbnz.govt. nz. ISSN 1177-7567 c ©Reserve Bank of New Zealand Non-technical Summary The Basel III net stable funding requirement, scheduled for adoption in 2018, requires banks to use a minimum share of stable funding, in the form of long-term wholesale funding and deposits, to fund their assets. We introduce a stable funding requirement (SFR) into a small open economy model featuring a banking sector with richly-specified liabilities; deposits as well as short-term and long-term bonds. The SFR regulates the proportion of loans financed by the ‘stable’component of the bank’s liabilities. The model is estimated for New Zealand, where a similar policy, the Core Funding Requirement, was adopted in 2010. A distinctive feature of the model is that it allows banks to issue short-term and long-term home currency-denominated debt overseas, in order to make loans in the small open economy. We evaluate how the presence of the SFR alters monetary policy trade-offs between the volatility in inflation, and volatility in other variables such as output, interest rates and exchange rates. A higher SFR raises the share of long term foreign bonds on the banks’balance-sheet and hence increases the economy’s exposure to shocks to the interest rate spread on long-term foreign debt. This in turn leads to macroeconomic volatility and hence worsens monetary policy trade-offs. However, since the SFR mainly affects the composition of bank funding rather than the cost, the SFR does not affect the transmission of other macroeconomic disturbances that do not affect the bank funding spread. Since bank funding spread disturbances have a negligible influence on the business cycle, the operation of monetary policy is little changed in the presence of the SFR. The additional macroeconomic volatility generated by the presence of the SFR can be diminished and monetary policy trade-offs can be improved if: (i) the central bank raises the interest rate to react systematically to increases in measures of credit growth in the economy and (ii) the SFR policy is varied over time to respond to credit growth.