Basel III liquidity coverage ratio and the operating target of monetary policy: the unintended discord

Proactive management of liquidity by a central bank is critical to achieve the operating target of monetary policy. The implementation of Basel III liquidity coverage ratio (LCR) regulations, however, could potentially alter the conditions in the unsecured segment of the money market and therefore influence the evolution of the operating target of monetary policy. This apparent discord requires empirical validation, which this paper attempts using data for the Indian banking system. Empirical estimates from a panel data model point to LCR-constrained banks in India borrowing at a higher rate in the call money market, and under alternative specifications of the model, the weighted average call rate or the operating target of monetary policy is pushed up by 5–7 bps. These banks also tend to borrow more and lend less in the call market, and when they lend, they seem to lend at about 5 bps higher. Even after introducing an additional variable in the model to account for the impact of liquidity conditions on the operating target, the LCR still remains a statistically significant determinant of borrowing spreads. The empirical evidence for India validates the presence of unintended impact of the LCR on the operating target of monetary policy, even as the limited nature of the impact does not point to the need for any revamp of the current operating framework.