Financial Plumbing and Monetary Policy

IMF Working Papers, June 20, 2014

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Focus: how changes in financial plumbing of the markets may impact the monetary policy options as central banks contemplate lift off from zero lower bound (ZLB).
Under proposed regulations, banks will face leverage ratio constraints.
As a result of quantitative easing (QE), banks want balance sheet “space” for financial intermediation/non-depository activities.
Regulatory changes are boosting demand for high quality liquid assets.
The paper discusses the role of repo markets, the importance of collateral velocity, and the need to avoid wedges between repo and monetary policy rates when leaving ZLB.

Leverage ratio constraints:
- Banks constrained by leverage ratios will have less balance sheet capacity for intermediation and non-depository activities.
Quantitative easing (QE) impacts:
- QE increases demand for balance sheet “space” among banks.
Demand for high quality liquid assets (HQLA):
- Regulatory changes increase demand for HQLA, affecting market liquidity and collateral availability.
Repo markets and collateral dynamics:
- Role of repo markets is central to transmission of monetary policy in the presence of constrained bank balance sheets.
- Collateral velocity is highlighted as a critical variable for market functioning.
- Avoiding wedges between repo rates and monetary policy rates is necessary when exiting the ZLB to ensure smooth policy transmission.

Policy options at lift off from ZLB are affected by:
- The interaction between leverage constraints, QE-induced balance sheet preferences, and elevated demand for HQLA.
Operational considerations:
- Central banks should monitor repo markets and collateral velocity closely.
- Policy design should aim to prevent persistent wedges between repo rates and central bank policy rates.