Reserve requirements as a financial stability instrument

Summary

Focus

Reserve requirements can be used as a macroprudential tool to manage credit and systemic risks. They can reduce the build-up of systemic risk and the frequency of financial distress episodes. However, during normal times, reserve requirements make loans more expensive, which reduces credit and could dampen economic activity.

Contribution

We estimate the net benefits of using reserve requirements. We estimate a panel vector autoregressive (VAR) model to capture the effect of reserve requirements on credit and industrial production. We then compare the cost with the benefits, which we estimate as the marginal reduction in the probability of financial distress episodes when reserve requirements are tightened.

Findings

We find positive net benefits from using reserve requirements. That is, the fall in industrial production after a tightening in reserve requirements is compensated for by the gains from a lower probability of financial distress. We also find that reserve requirements have a stronger effect in emerging markets than in advanced economies – both in terms of costs and benefits. Finally, uniform reserve requirements have a stronger effect than reserve requirements by maturity or currency.

Abstract

We quantify the trade-offs of using reserve requirements (RR) as a financial stability tool. A tightening in RR reduces the amplitude of the credit cycle. This lowers the frequency and strength of financial stress episodes but at a cost of lower growth in credit and economic activity. We find that the gains from a lower probability and magnitude of financial stress episodes are greater than the costs from the initial reduction in economic activity. In addition, we find that RR have a stronger effect on emerging market economies than in advanced economies, both in terms of costs and benefits. Finally, we find that uniform RR have a stronger effect than RR that differenciate by maturity or currency.

JEL classification: E44, E58, F41, G01, G28

Keywords: reserve requirements, macroprudential policy, financial stress episodes, early-warning system, financial cycle