–Basel III Adjustment Period Might Be A Challenge To Monetary Policy
MILAN (MNI) – The positive effects on the economy of increased
financial stability due to the Basel III reform will outweigh the cost
of the reform, ECB Executive Board member Lorenzo Bini Smaghi said
Wednesday.
“Real economic activity will profit from such increased stability
and, in my view, outweigh the direct cost of the regulation, especially
in the long run,” Bini Smaghi said in prepared remarks for delivery at a
conference here today.
“There is of course an issue of gradualism and calibration, with a
view to avoiding the two extremes — an excessively abrupt adjustment
and an everlasting phasing-out,” the central banker noted. “But it seems
to me that this issue has been dealt with in a reasonable way,” he said.
The changes in the financial system caused by the Basel III
regulation will have to be factored in also by monetary policy
authorities, Bini Smaghi observed.
“For central banks, the changes may be far-reaching, ranging from
the transmission mechanism of monetary policy to interactions with
several aspects of the operational frameworks,” he remarked.
“At the ECB we are actively working on these issues to ensure that
our monetary policy continues to be conducted in an effective way, also
in the new environment, so as to maintain price stability, our primary
goal,” Bini Smaghi stressed.
The new rules are likely to impact on the markets for liquidity and
on the demand for central bank refinancing, “thereby affecting the
transmission mechanism of monetary policy,” he argued.
The increased demand for and lower supply of longer-term financing
relative to short-term financing, stemming from the introduction of the
liquidity coverage ratio under Basel III, is expected to lead to a
relative increase of interest rates for maturities longer than the
threshold established by the regulation (30 days), compared with shorter
maturities, Bini Smaghi explained. “This would imply a steeper money
market yield curve,” he said.
“Less active money markets, and a corresponding higher volatility
of short-term interest rates, could make the transmission of monetary
policy signals more difficult and less precise,” the Executive Board
member pointed out.
Moreover, an increase in the steepness of the money market yield
curve would affect the transmission mechanism and the information
extracted from the yield curve for monetary policy purposes, Bini Smaghi
noted. “To the extent that this effect is well understood and
anticipated, central banks will be able to adjust their policies to the
changed market environment,” he said. “Transitory changes during an
adjustment period may pose, however, some challenges.”
The changes in the liquidity regulation can also have an effect on
the demand for central bank liquidity, because funds on central bank
accounts obtained through open market operations or through a lending
facility will count as liquid assets for the liquidity coverage ratio,
Bini Smaghi explained.
“Therefore, the newly proposed regulation would make it more
attractive to acquire liquidity from central banks,” he asserted. A
structurally higher demand for central bank refinancing combined with an
unchanged liquidity supply by the central bank would however cause
tender rates at central banks’ open market operations to increase, he
noted.
“The ECB could accommodate this demand by increasing the size of
its open market operations,” the Executive Board member explained. But
while in times of crisis, a stronger intermediation role by the central
bank can be beneficial, in the long run it might crowd out market
activity, and reduce incentives for peer monitoring, he cautioned. “This
could in turn increase risktaking behaviour. These are of course
side-effects of the proposed regulations which should not be neglected,”
he said.
Not only the volume, but also the variation, of demand for central
bank funding over time could be affected by the regulation, Bini Smaghi
continued. It is possible that on some days banks will seek financing
from the central bank for regulatory purposes more than they do on other
days, he pointed out. This would lead to a time-varying demand for
liquidity in central banks’ open market operations and a higher
volatility of interest rates.
“In particular, such effects would depend on the enforcement of the
regulatory measures, whereby calendar effects with temporary peaks in
demand could arise, which tend to ‘pollute’ the control of short-term
interest rates,” he said.
Basel III could also make central bank refinancing for longer
maturities more attractive than for shorter ones, Bini Smaghi remarked.
For regulatory purposes, banks might try to shift their participation in
the ECB’s open market operations from the one-week to the three-month
operations, he said.
However, the rates on the main refinancing operations with a
one-week maturity convey the monetary policy stance, Bini Smaghi pointed
out. “For this reason, the ECB will monitor carefully whether a shift in
demand from short-term to longer-term operations will take place that
could lead to reduced participation in the main refinancing operations,”
he said.
“Should this reduction occur — which seems highly unlikely, but at
this juncture it is difficult to quantify the precise extent — the
ability of the central bank to control short-term rates, and thus to
signal its monetary policy stance, might be affected,” the Executive
Board member cautioned. “The ECB could adapt its liquidity management
practices in order to guarantee a continued high demand for short-term
refinancing,” he said.
–Berlin bureau: +49-30-22 62 05 80; email: twidder@marketnews.com
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