Working Paper No. 548
By Christopher Jackson and Joseph Noss
Money markets play an important role in the implementation of monetary policy. Their structure and dynamics have, however, changed significantly in recent years. In particular, a number of new banking regulations will affect the behaviour of money market participants, and so have the potential to affect money market interest rates. This paper offers a model to examine how prudential regulation might affect interbank overnight interest rates where the central bank implements monetary policy using a corridor system. Combined with a set of assumptions as to the cost banks might incur in meeting regulatory capital requirements, it offers a framework with which to explore how such prudential regulation might affect the dynamics of overnight interest rates. The results — which are illustrative — estimate the interest rates at which banks might borrow and lend reserves overnight in the presence of prudential regulation. They suggest that risk-weighted capital requirements might increase the average level of overnight interbank interest rates, while the regulatory minimum leverage ratio might decrease it. If applied to real-world data on central bank reserves balances and regulatory metrics, this model also offers an insight into how central bank policymakers could — if they so choose — amend their operational frameworks to account for the effects of regulation.