Monetary Policy Transmission and the Role of High- and Low-Quality Liquid Assets

Abstract

Traditionally, when monetary policy tightens, it reduces banks' lending activities, which is more pronounced for banks with less liquid balance sheets. In such a scenario, liquid assets have been considered stabilizing mechanisms for banks throughout monetary policy cycles. This paper revisits the role of liquid assets in the transmission of monetary policy to the banking system by focusing on the interaction between high-frequency identified monetary shocks and four key liquidity ratios: high-quality, low-quality, total liquidity, and liquidity coverage ratios. By considering these ratios, this paper uses local projections to estimate banks' heterogeneous responses to monetary policy shocks regarding deposit flows, lending activities, liquidity creation, and profit margins. The findings suggest that the interactions between monetary tightening shocks and high-quality liquidity ratios stabilize banks' activities. In contrast, the interaction between shocks and low-quality liquidity ratios tends to amplify monetary policy transmission. This paper highlights the importance of differentiating between the qualities of liquidity and suggests that only certain qualities of liquid assets work as stabilizers during monetary cycles.

Keywords: Banks, Monetary Policy, High-quality liquid assets, Low-quality liquid assets, liquidity coverage ratios

JEL Classification: E43, E44, E52, E58, G21