Banks’ interest rate setting and transitions between liquidity surplus and deficit

Grishina D., Ponomarenko A.

Assuming that a central bank is successful in steering money market interest rates, commercial banks’ loan rate setting behaviour is not expected to change during a transition between liquidity surplus and deficit. However, this logic does not hold if the interest rates for the lending and borrowing activities of an individual bank on the money market do not coincide. The authors argue that in this environment, it may be appropriate to adjust the loan rates when a bank transitions between liquidity surplus and deficit. This strategy is fundamentally different from linking the loan rates to the average cost of funding. The magnitude of such loan rate adjustment is limited by the (usually moderate) spread between the funding and investment money market rates.

Banks’ interest rate setting and transitions between liquidity surplus and deficit