New CEPR Policy Insight - The fragile triangle: Price stability, bank regulation and central bank reserves

Wednesday, October 6, 2021

The tightening of bank capital requirements after the global financial crisis of 2007-09 acted as a disinflationary force, reducing banks’ potential for money creation and investments. But as that tightening comes to an end, and with banks maintaining large central bank reserves, this disinflationary force is likely to disappear. 

Indeed, according to a new CEPR Policy Insight by Hans Gersbach, there is a risk of weakening anchors for inflation expectations after the Covid-19 pandemic. He concludes that to protect the ‘fragile triangle’ of price stability, bank regulation and central bank reserves, it will be important to control bank money creation and to mitigate the inflation risks associated with it.

Hans Gersbach (Center of Economic Research at ETH Zurich and CEPR).  

Available for download here >>>

While there has been substantial debate about whether inflation – possibly even high inflation – might return after the pandemic, the role of bank capital regulation in bank money creation and inflation is often overlooked. This CEPR Policy Insight explains how money creation by banks is linked to bank regulation and central bank reserves, and how an examination of this link can contribute to our understanding of future inflation risks in the post-Covid world. 

The global financial crisis of 2007-09 showed that banks were not well capitalised enough to survive times of serious hardship. Bank regulators were urged to take action and so enforced stricter capital regulation post-crisis. Tighter capital requirements have subsequently acted as a disinflationary force over the last decade. 

Once economies return to normal, and as the strengthening of capital requirements now seems to be coming to an end, banks are expected to have greater potential to engage in investments and private money creation. In particular, small increases in bank equity funding, or situations where banks are far beyond regulatory bank equity requirements, will allow banks to increase investments and asset purchases considerably, financed with bank deposits. 

In turn, this could contribute to a weakening of the anchor for inflation expectations and to upward pressure on inflation. This effect is particularly relevant in the presence of negative supply shocks and as potential liquidity constraints for money creation by banks are currently weakened by large reserve balances at central banks, which have been pushed to even higher levels in the wake of Covid.

Figure: Total reserve balances maintained by private banks at the Federal Reserve Banks (USD), the Bank of England (GBP), the Bank of Japan (JPY), and the European Central Bank (EUR):

Sources: Bank of Japan, Bank of England, European Central Bank, Federal Reserve; as of 17/06/2021.

Looking forward, the report makes it clear that when the tightening of bank equity regulation comes to an end, there should be greater concern about banks that hold large reserves.

The author suggests potential remedies that could reduce the risk of banks engaging strongly in money creation, if capital regulation is not further strengthened and thus can no longer exert disinflationary pressure. He explores whether a reduction of central bank reserves, interest payments on reserves, or refraining from interest payments on reserves, coupled with liquidity regulation, can mitigate these risks.

Read an accompanying VoxEU column here >>>.

Find a full list of CEPR's Policy Insights here >>>