Surplus Bank Liquidity


It has often been noted that when banks retain liquid funds above of their desired level, the monetary policy transmission mechanism may be considerably differentiated. The scope of this paper was to explain a simple macroeconomic model that permits a formal analytical examination of the implications of surplus bank liquidity for the effectiveness of monetary policy. In this model, a cost channel is established by assuming that firms need to borrow to pay wages prior to the sale of their product. Banks define both deposit and lending rates, in the second case as a premium over the cost of borrowing from the central bank. This premium depends on the firms' net worth, as supported by Bernanke & Gertler. Firms are not restricted by binding credit constraints but can only borrow funds at ever higher interest rates. A demand equation for surplus reserves is also obtained explicitly, following the assumption that banks feel insecure about cash withdrawals by the households.

This simple model was used to study the financial and actual effects of a change in the cost of borrowing by the central bank and the necessary reserve ratio, in a typical scenario where surplus liquidity (defined as a condition where actual surplus reserves exceed the wanted value) does not exert any direct effect on the bank's pricing behavior. It was proven that because cumulative supply and cumulative demand both fall, prices can either increase or decrease. In the first case, the familiar Bernanke-Gertler financial accelerator effect was recognized, as a result of internal changes in the net worth of the risk premium. In the second case though, a financial decelerator may appear, for related reasons.

Afterwards the analysis was expanded to consider the case of surplus liquidity and consider symmetric and asymmetric effects that can be exerted on bank pricing policies. In the former case, deposit rates are supposed to react symmetrically to changes in monetary policy mechanisms, while in the latter case they are supposed to demonstrate upward rigidity only in reaction to these changes. Under symmetric effects, it was found that surplus liquidity can lead to a price paradox, an inflationary effect of restrictive monetary policy. Under asymmetric effects, banks may cut deposit rates following either a drop in the refinance rate or a raise in the required reserve ratio, given that both policies lead to a decrease in the supply of deposits by the households. As a result, the model provides a logic for the decision to increase the required reserve ratios to neutralize surplus liquidity. Also, it was found that even if banks decide not to adjust deposit rates at all, after a raise in the refinance rate, under surplus liquidity the stagflationary effect linked with a firm monetary policy in the existence of a cost channel may be intensified.

The case where surplus liquidity leads to asymmetric behavior in applying lending rates, by encouraging banks to relax credit standards, is also considered. It was argued that such behavior can bring a decrease in the risk premium charged by banks, which may be bulky enough to counterbalance the direct effect of a raise in the refinance rate on the lending rate. In such circumstances and providing that the effective actual wage increases, a limiting monetary policy is again possible to be stagflationary.

Therefore, this model proves, as supported less formally by other observers, that the effectiveness of the monetary policy can be limited in an environment where surplus liquidity in the financial system reigns. Additionally, it also shows that it could be in fact even worse. The monetary policy could threaten macroeconomic stability by tending to higher inflation and intensified limiting effects on output.

The presented analysis can lead in several interesting paths. Firstly, even though increases in the reserve requirement rate were proven to be an effective monetary policy mechanism under surplus liquidity, the purpose for using it can be limited if reserves held at the central bank have to be compensated at below market interest rates. Additionally, if the raise in liquidity is caused by cyclical factors (for example large increases in capital inflows), the potential adverse long term effect of higher needed reserve ratios on financial intermediation can generate dynamic tradeoffs and further limit the use of these ratios as mechanisms of short term macroeconomic management.

Secondly, easing credit standards to motivate the demand for loans can also end up undermining the quality of banks' portfolios, therefore making them more exposed to default. In that sense, surplus liquidity can make the financial system even more sensitive to crisis. A vital issue therefore is to analyze which policies, in a second class environment, can effectively moderate increased vulnerability. This can offer a different view on the role of reserve requirements.

Thirdly, a broader list of supportive assets in the economy may be considered, to better account for possible portfolio movements induced by surplus liquidity. As noted above, surplus liquidity may lure banks toward riskier utilization of deposits, not only lending to firms, but also investing in sectors whose collateral value may be highly unstable, such as the real estate market. Higher exposure to risk could abate the banks' balance sheets and increase their exposure in a recession.

It is also essential to expand empirical research by observing a wider group of countries whether there is evidence that surplus liquidity actually leads to asymmetric bank pricing activities. It is even crucial to establish whether the rate of adjustment of deposit rates differs depending on whether surplus liquid reserves are above or lower an estimated equilibrium value. The error-correction method used by Scholnick (1996) and Sander and Kleimeier (2000) could be adapted and used for that purpose. Studies like the above are crucial for strengthening our knowledge of how asymmetric bank pricing behavior can affect the monetary transmission mechanism.

Dealing with the crisis

Therefore, the question posed is what interventions are necessary in order to overcome the crisis and for the country to recover and come to a new growth path with strong prospects. As argued above, the ideal solution seems to be the adoption of the Keynesian theory as well as the implementation of a policy in accordance with Keynes's ideas and principles. The creation of liquidity but also the easier accesses of middle-sized businesses to modern financial tools are top priorities, together with the need to maintain employment during this considerably hard period. Moreover, the way out of the crisis requires radical changes in the growth model that the country has been following up to now. This period, which is crucial both for the economy and the society, is a challenge and an opportunity for breakthroughs and changes. The target must be the shift to a more outward-looking growth model, which will include investments in quality, innovation and the ‘green' economy, support of entrepreneurship, boost of domestic production, promotion of long-term savings, as well as substantial efforts towards the modernization and reorganization of the public sector.

The aim shall be the restoration of competitiveness and the boosting of the economy's export orientation, but also the building of an effective social welfare state that will guarantee every citizen's access to quality products and services of a social character. Both the direct actions to reverse the current recess climate and the adoption of a new growth model for the country assume the existence and effective operation of a dynamic and responsible banking and financial system, which can respond satisfactorily to the new increased internal and external demands and play a significant role in the Balkan area.

For this reason, reforms are necessary within the frame of operation of the banks and the capital markets in order to create the conditions for stricter supervision, stricter capital adequacy indices, better risk management, more favorable financing of sound businesses, especially small and middle-sized ones, and of course of greater transparency and information flow to their customers. Finally, the banking sector must contribute to the smooth operation of the economy so that the serious problem of liquidity is dealt with, in order to reverse the negative climate and investment slowdown.

The main ingredient of the release from the current crisis is the need to draw a new growth path for the economy. There is a clear and present danger that the causes of the crisis will be forgotten and the opportunity will be lost for a breakthrough and for changes in the administrative, productive and development model. The current model, which is based mainly on the increase of domestic demand and private consumption, does not seem to be able to continue.

Within this framework there are some basic directions that would help reconstruct the Greek economy to come out of the present crisis:

  • Support of the purchasing power of the middle-income families and assistance to the socially vulnerable groups. Reduction of the taxation of natural persons through the use of more grades on a progressive-proportional scale with indexation of the tax scale so that incomes of employees, self-employed professionals and pensioners do not shrink as a result of the inflation rate increases.
  • Support of the real economy and middle-sized businesses. Increase of public spending for education, sustainable development, renewable sources of energy, productive restructuring of sectors and areas that are severely hit by the crisis through the use of targeted incentives, financing of energy-saving measures to make sectors more viable as well as support of entrepreneurship through the simplification of bureaucratic procedures and the use of modern technologies.
  • Fighting unemployment through the support of employment and subsidies. Support of businesses that preserve various job positions though incentives and subsidies for each new position. In addition support of social work with full social security rights for supporting the jobless and recently discharged in areas that are in need of manpower.
  • Return to fiscal stability. Rationalization and restructuring of public spending. The reduction of elastic consumer spending that leads to the waste of public money is as important as the increase of productive investment in the direction of co-financed projects that create new jobs.
  • Tax system reform. Preparation of budgets that secure effectiveness, transparency and accountability in the management of public funds.
  • State intervention and the creation of a stricter frame of supervision and monitoring of the financial system as well as support of the market's liquidity.
  • Support of the banks' capital adequacy through the increase of their equity, support of the efficiency of the financial system's supervision system within a new frame which will regulate every financial operation and also higher participation of the state in the national bank for the creation of a strong pole of public interest in the financial system. Capital flows are international therefore a new frame of rules and principles makes global cooperation necessary. In addition, the size and extent of the global financial crisis makes cooperation important for the creation of a unified supervisory body as well as of a European organization for the supervision and monitoring of the financial system.

For the above reasons, reforms are necessary within the frame of operation of the banks and the capital markets. The Bank of Greece, with the reinforcement of its supervisory, monitoring and regulatory role, may and must be the catalyst for this prospect.

Finally, it must be made clear that in the present critical juncture, it is the responsibility of banks to contribute to the smooth operation of the economy in a substantial manner, with the financing of both businesses and citizens, the support of investments, and the effective management of national savings. Moreover, banks must face an important challenge: the need to restore their relationship with the business world and the society, through the implementation of more rational profit margins, the denouncing of the model of mindless consumption which they have advocated and helped preserve till now, and, of course, through the support of productive investment.


Current developments in international financial markets strongly indicate the need for more effective regulation and supervision. Although it is not easy to determine the ideal level of regulation, the events the world is experiencing from the beginning of the global financial recess in August 2007, suggest that the supervision of the financial system carried out has serious gaps. The experience coming from the current financial crisis and from the history of economic development in recent centuries, shows that it is impossible to entirely predict and prevent future crises. But there is the possibility to limit their size and frequency by revising the banks' international supervisory framework. During the '90s and up to the summer of 2007, there was a global trend towards the elimination of regulation by the central banks and assigning it to other supervisors. A typical example is the supervisory model of the United Kingdom when the country experienced the “banking run”, i.e. the sudden deposits withdrawal that followed the confidence drop towards the Northern Rock bank and its subsequent collapse in September 2007. According to many economists, the above model has proved inadequate during the current crisis and the introduction of a new approach is necessary.

Within the context of the whole discussion on the future of the financial system the importance of two very important key factors need to be emphasized. The first is the pursuit of close supervision by the central banks. The current financial crisis has shown that the countries whose central banks have direct access and thorough knowledge of supervisory data of the whole banking sector, both at macroeconomic and microeconomic level, were able to face the impact of the crisis with fewer losses. The reason for this was that the central banks applied both micro and macro supervision. This policy allowed vital and comprehensive decisions on strengthening the liquidity and solvency of each bank separately, but also of the entire banking system. The need for closer cooperation between the central bank and the supervisory body in exchanging financial and supervisory information at a European level is noted in the recent report by Jacques de Larosiere (2009), Amongst other things, he proposes the creation of a European Council of Systemic Risk, under the regulation of the European Central Bank, giving a supervisory role in this eurosystem.

The second factor is that banking supervision should be governed by technocratic and rational criteria, fully independent and free from any temporary political considerations and influences. The experience of the recent months suggests that countries and areas where the power of supervision is not practiced from completely independent bodies and was prone to political influence and interference enhanced the results of the crisis.

Therefore, the main objective for the economies throughout the world should be the adoption of an economic policy model inspired by the principles and rules of the Keynesian theory. This will help overcoming the effects of the global financial crisis and act as a shield against future outbursts. Having Keynes's theory as their guide, the aim of the future economic policies should be to safeguard the banking system. It is evident, more than ever, the need to avoid repeating the collapsing examples of recent economic systems, as the reality shows the dramatic impact of this collapse at every level, local and international, economic and interpersonal. It is obvious that the economic crisis is not just banks and big businesses, did not stay in the headlines of newspapers and statistical tables, but it spread in everyone's reality, were people stayed silent spectators to the diminishing of their wealth and the collapse of their own life.

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