Liquidity and Monetary Transmission: A Quasi-Experimental Approach

Bank liquidity requirements have tightened greatly since the financial crisis. There is still little evidence about what effect this has had on credit supply and the monetary transmission mechanism. We use the UK’s experience from 2010-15 as a laboratory by combining a novel dataset on bank liquidity requirements with a near-universal, loan-level dataset on UK mortgages. We exploit the design of quantitative easing operations as a natural experiment, where some banks were randomly given more liquidity. We find that more liquid banks charge higher mortgage interest rates, and pass on (significantly) less of their changes in funding costs. This suggests the transmission mechanism is weaker in the presence of higher liquidity requirements and monetary policy may have to be more responsive.

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