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SUOMEN PANKKI | FINLANDS BANK | BANK OF FINLAND

RESERVE REQUIREMENTS AND THE BANK LENDING CHANNEL IN CHINA

Zuzana Fungáčová (Bank of Finland)

Riikka Nuutilainen (Bank of Finland)

Laurent Weill (University of Strasbourg & Bank of Finland)


MOTIVATION

¨ The aim of this research is to provide new evidence on the

transmission of monetary policy in China.

¨ This question is of high importance as banks play a key role in the

Chinese financial system and provide most of the funding to firms.

¨ Bank loans are the largest source of external funding for firms with

75% of all external funding sources at the end of 2010.

¨ We investigate the effectiveness of the bank lending channel which

is a key channel for the transmission of monetary policy.


MOTIVATION

¨ The bank lending channel is based on the idea that, owing to

imperfect substitutability between bank lending and bonds,

monetary policy influences the supply of bank loans.

¨ A monetary policy tightening increases the opportunity cost of

holding deposits, resulting in a decrease in bank lending in line with

the reduction in funding sources.

¨ It has been widely investigated in the US and in Europe (e.g.,

Gambacorta, 2005; Fungacova, Solanko and Weill, 2014), but less

so in China (Gunji and Yuan, 2010).


MOTIVATION

¨ Major difference between China and developed countries:

¨ In China, reserve requirements ratio (RRR) has been intensively

used as a regular policy tool, especially since the wake of the global

financial crisis.

¨ In 2007 alone, the reserve requirements ratio was adjusted ten

times, and it was changed 15 times between 2010 and 2013.

¨ To gauge the monetary policy transmission mechanism in China, it

is therefore necessary to assess the effectiveness of this monetary

policy tool.


AIM OF THIS PAPER

¨ To examine the effect of changing the reserve requirements

ratios on the transmission of the monetary policy through the

bank lending channel in China.

– We analyze the reaction of loan supply to monetary policy actions using the

methodology of Kashyap and Stein (1995, 2000).

– Methodology commonly used in the literature on the bank lending channel (e.g.

Gambacorta and Marques-Ibanez, 2010; Fungacova, Solanko and Weill, 2014).

¨ We use a large dataset on Chinese banks for 2004-2013.

– Unlike previous studies on Chinese banks where only the data on the largest or

listed banks are used (e.g., Gunji and Yuan, 2010), we have over 170 banks in

our current dataset.


CONTRIBUTION

1. Evidence on how changing the reserve requirements influences

bank lending in China.

¨ We also consider other monetary policy tools including i.e. the

overnight interbank rate to assess whether reserve requirement

ratios are more effective than other monetary policy instruments.

¨ As such, the impact of reserve requirement ratios is of prime

concern not only in absolute terms but also relative to other

monetary policy tools.


CONTRIBUTION

2. Helps understanding how bank ownership can influence the

transmission of monetary policy.

¨ Coexistence of different types of banks in terms of ownership in the

Chinese banking industry.

¨ Bhaumik, Dang and Kutan (2013): evidence in India that bank

ownership influences monetary policy transmission.

¨ We are therefore interested whether the effectiveness of changes in

reserve requirements is influenced by bank ownership.


IMPLICATIONS

1. It provides evidence on the effectiveness of the reserve

requirement ratio for the bank lending channel.

¨ As such it helps understand the transmission mechanism of

monetary policy.

2. We contribute to the debate concerning bank ownership in

China.

¨ We inform on the consequences of privatization and foreign entry

policies on the transmission of monetary policy.


THE MONETARY POLICY FRAMEWORK IN CHINA

¨ Contrary to central banks in the advanced economies, the PBC

employs a variety of policy instruments:

– price based tools, for example benchmark and other policy interest rates

and open market operations

– quantity based tools, such as reserve requirement ratios, window

guidance and other administrative measures.

¨ Monetary policy framework in China has evolved together with the

economic development.

¨ The direct credit plans were abolished in 1998, when the policy was

shifted to a more market based direction.



¨ RRR is considered to be among the most important policy

instruments in China.

– Changes in reserve requirements tend to signal the policy aim to tighten or

loosen the bank lending, and hence, the monetary policy stance.

– In 2004–2013 the RRR has been changed more frequently than the benchmark

interest rates.



¨ All banks in China are required to hold central bank reserves, but

the RRRs across banks differ.

– In 2008 the RRR system was differentiated for different types of banks.

– The largest commercial banks currently have two percentage points higher RRR

than the smaller banks.

– In 2011 the PBC introduced an opaque ‘dynamically differentiated RRR’ scheme

with an aim to countercyclically guide the aggregate credit supply.

– The RRRs for individual banks are adjusted taking into account, for example, the

credit portfolio, soundness and systemic importance of the bank (People’s Bank

of China, 2012, p. 15).



¨ Most of the policy decisions, including interest rate changes, have to

be approved by the State Council before their execution.

¨ Nevertheless, the reserve requirements ratio (RRR) can be

changed directly by the People’s Bank of China (PBC). That is why

this instrument plays a special role in the Chinese monetary policy.

¨ Hence as the PBC enjoys greater discretion in making reserve

requirement ratio decisions, it makes RRR a more timely instrument.


LITERATURE REVIEW

¨ Few empirical studies on the monetary policy transmission in China

using the different instruments with somewhat contradictory

findings.

– He, Leung and Chong (2013): the Chinese economy responds strongly to total

lending and money supply shocks and only mildly to benchmark lending rate,

market interest rate and other “market-based” shocks in 1998–2010.

– Fernald, Spiegel and Swanson (2015): the RRR and benchmark interest rate

instruments are found to be effective in determining inflation and economic

activity in 2000–2013. Money supply and loan growth play insignificant role =>

monetary policy transmission mechanism in China is beginning to look ‘more

standard’.


LITERATURE REVIEW

¨ Only one study examining the bank lending channel with the

Kashyap and Stein (1995, 2000)’s approach like us: Gunji and Yuan

(2010).

– On a small sample of 19 banks for the period 1985-2007, they consider several

monetary policy instruments including reserve requirements. Focus on the

influence of profitability.

– They find limited evidence for the bank lending channel when considering banks’

responses to monetary policy depending on their capitalization, liquidity, and size

(only for size).

– They observe that greater profitability of banks makes them less sensitive to

monetary policy.


LITERATURE REVIEW

¨ Other related studies from Nguyen and Boateng (2013), Xiong

(2013) and Hou and Wang (2013) looking respectively at the impact

of involuntary excess reserves, implementation of capital

requirements and banking marketization on the bank lending

channel.


DATA

¨ Yearly bank-level financial statement data of Chinese banks from

Bankscope complemented by hand-collected data from annual

reports

¨ Unique dataset that contains over 950 observations for 170 banks

i.e. higher than in other studies

¨ Time period 2004 – 2013

¨ Information on monetary policy tools from the website of the PBC

¨ Macroeconomic variables from National Bureau of Statistics of

China

¨ Classification of banks by the Chinese Banking Regulatory

Commission


TYPES OF BANKS

¨ Large commercial banks– Four main banks established in 1984 (ABC, BoC, CCB, ICBC) and Bank

of Communications– Provide nationwide wholesale and retail services– Very large publicly listed institutions also at the global scale– Account for 43% of the banking sector assets (despite their growth, their

share has been declining)– Despite presence of foreign investors, still majority state-owned

¨ Joint-stock commercial banks– 12 joint-stock commercial banks, operate nationwide– Constitute 18% of total banking sector assets – their share has been

increasing at the expense of large state-owned banks– Operate on a commercial basis and have private domestic and foreign

shareholders but the state-owned entities are still important shareholders for many of these banks


TYPES OF BANKS

¨ City commercial banks– Originally carried out the local government lending operations and some

of the banks are still owned by the local governments– Typically operate in their local banking markets serving especially local

small and medium businesses– Important in providing financing to the SMEs– Account for about 10% of banking sector assets (growing share)

¨ Rural financial institutions– Serve rural population and usually operate within the small township or

village– Account for about 13% of banking sector assets– Transformation of rural credit cooperatives into rural commercial banks

and rural cooperative banks


TYPES OF BANKS

¨ Foreign banks– Account for about 2 % of the banking sector assets– Around 40 foreign financial institutions operating in China– First allowed to offer just foreign currency services, then from 2004

could provide local currency services and after December 2006 in connection to WTO agreement foreign banks could also enter retail market

¨ Foreign ownership in Chinese banks– Many of the banks where the state holds a majority stake also have

foreign owners– Nowadays still restrictions

• maximum foreign share for individual investor in commercial banks is 20%

• maximum total foreign investment is 25%


METHODOLOGY

¨ Following Kashyap and Stein (1995,2000) and Ehrmann et al. (2003) changes in a bank’s loan supply are estimated

where i identifies the bank, t time period, Lit total loans to private non-banking sectors, MP monetary policy indicator, GDP real GDP, Xi bank-specific characteristics

¨ Control variables lagged one period to ease possible endogeneity

¨ Panel fixed-effect estimations

tittiitiititiiti MPXeXdGDPcMPbaL ,1,1,, )log(


VARIABLES

¨ Monetary policy indicator– Main indicator: reserve requirements ratio reported for the

largest banks, small and medium banks and rural credit cooperatives

– Other indicators: overnight interbank rate, lending rate

¨ Bank-specific variables – Bank size (log of total assets)– Capitalization (equity to total assets)– Liquidity (liquid assets to total assets)


RESULTS

¨ Main results with reserve requirement ratios as monetary

policy instrument

– 2004 – 2013

– Subperiods accounting for active usage of reserve requirements

and crisis period

¨ Other monetary policy instruments

¨ Different types of banks


MAIN ESTIMATIONS

Full period 2006-2013 2008-2013

MP (reserve requirements) -0.007** -0.008** -0.012*** [0.003] [0.003] [0.003]

Capitalization 1.406*** 1.582*** 1.618*** [0.501] [0.454] [0.531]

Liquidity 0.460*** 0.386*** 0.547*** [0.141] [0.110] [0.122]

Size -0.132*** -0.142*** -0.199*** [0.041] [0.038] [0.067]

MP×capitalization -0.133* -0.178* -0.206* [0.079] [0.092] [0.106]

MP×liquidity 0.030 0.032 0.009 [0.055] [0.056] [0.062]

MP×size -0.001 -0.001 -0.002* [0.001] [0.001] [0.001]

GDP 0.023*** 0.023*** 0.048*** [0.004] [0.004] [0.007]

Constant -0.003 -0.005 -0.221*** [0.038] [0.040] [0.064]

Observations 968 914 741

R-squared 0.160 0.194 0.228

Number of banks 170 166 153


MAIN RESULTS

¨ Loan growth adversely affected by tightening reserve requirements– Estimated coefficient is significant and negative in all

specifications– Reserve requirements are effective monetary policy instrument

¨ Most monetary policy interaction terms not significant– Bank size and liquidity do not influence how bank lending reacts

to changes in monetary policy– Capitalization is negative and significantÞ Reserve requirements do not influence transmission of monetary

policy through the bank lending channel

¨ Results valid for different subperiods


ESTIMATIONS WITH OTHER MONETARY POLICY INSTRUMENTS

Interbank rate Lending rate

Specification (1) (2)

MP -0.023*** -0.031*** [0.004] [0.007]

Capitalization 1.252** 1.146** [0.507] [0.483]

Liquidity 0.584*** 0.565*** [0.129] [0.121]

Size -0.147*** -0.149*** [0.039] [0.037]

MP×capitalization -0.094 -0.305 [0.176] [0.237]

MP×liquidity -0.002 0.137 [0.086] [0.153]

MP×size -0.002 -0.008*** [0.002] [0.002]

GDP 0.025*** 0.027*** [0.004] [0.004]

Constant -0.022 -0.052 [0.046] [0.046]

Observations 967 968 R-squared 0.156 0.168 Number of banks 170 170


OTHER MONETARY POLICY INSTRUMENTS

¨ Negative and significant coefficients for all monetary policy instruments – All the instruments seem to be effective

¨ Interactions between monetary policy and bank-specific variables– Never positive and significant, mostly not significant

=> No support for the bank lending channel i.e. neither small, nor less-capitalized or less-liquid banks incur greater increase of loan supply when MP is relaxed

¨ Results in line with the main findings– No bank lending channel regardless of the MP instrument– In line with related studies (e.g. Gunji and Yuan, 2010)


ESTIMATIONS FOR DIFFERENT TYPES OF BANKS

Big5 Joint-stock CCB RCB Foreign

MP -0.007** -0.007** 0.006 -0.007** -0.011*** [0.003] [0.003] [0.007] [0.003] [0.003]

MP× type 0.017 -0.003 -0.018** -0.010*** 0.034***

[0.023] [0.007] [0.008] [0.004] [0.010]

Capitalization 1.396*** 1.376*** 1.416*** 1.406*** 1.397*** [0.505] [0.516] [0.485] [0.501] [0.478]

Liquidity 0.460*** 0.456*** 0.488*** 0.469*** 0.516*** [0.141] [0.141] [0.139] [0.141] [0.137]

Size -0.133*** -0.130*** -0.133*** -0.132*** -0.131*** [0.042] [0.040] [0.039] [0.041] [0.038]

MP×capitalization -0.133* -0.137* -0.229** -0.136* -0.048 [0.080] [0.081] [0.094] [0.080] [0.098]

MP×liquidity 0.031 0.035 0.035 0.034 -0.005

[0.056] [0.058] [0.083] [0.057] [0.030]

MP×size -0.001 -0.000 -0.006** -0.001 0.000 [0.002] [0.001] [0.002] [0.001] [0.001]

MP×capitalization×type 0.767*** 0.132 0.128 -0.030 -0.337** [0.120] [0.119] [0.166] [0.150] [0.155]

MP×liquidity×type -0.259* -0.032 -0.024 -0.141** 0.062 [0.131] [0.066] [0.081] [0.056] [0.098]

MP×size×type -0.004 0.001 0.007*** -0.003 -0.015 [0.007] [0.002] [0.003] [0.004] [0.013]

GDP 0.023*** 0.023*** 0.023*** 0.023*** 0.024*** [0.004] [0.004] [0.003] [0.004] [0.003]

Constant -0.001 -0.002 -0.007 -0.004 -0.010 [0.039] [0.038] [0.036] [0.039] [0.034]

Observations 968 968 968 968 968 R-squared 0.162 0.161 0.172 0.162 0.186 Number of banks 170 170 170 170 170



¨ Impact of changes in reserve requirements on loan

growth differs across types of banks

1. Interaction term between MP and the type of banks– Significantly negative for city commercial and rural commercial

banks => loan growth of these banks is more adversely affected

by a tightening in reserve requirements

– Significantly positive for foreign banks => foreign banks can

weaken the effectiveness of monetary transmission (Jeon and

Wu, 2014)



2. Differences in transmission of monetary policy through

bank lending channel across bank types – limited

evidence for the bank lending channel- Interaction term for capitalization positive for Big 5 => less-

capitalized Big 5 tend to increase their credit supply more when

RRR are reduced

- Interaction term for size positive for city commercial banks =>

smaller city commercial banks increase their supply more when

RRR are reduced



¨ Estimations with other monetary policy proxies (interbank rate, lending rate) provide results in line with reserve requirements

¨ Overnight interbank rate as monetary policy proxy provides slightly different resuls– Interaction term between MP and type of bank is significant for

joint-stock, city commercial and foreign banks– No results supporting bank lending channel

¨ Estimations for different types of banks overall– Some evidence for bank lending channel for some types of

banks– Stress the importance of bank type


CONCLUSION

¨ Three main findings.

¨ 1. The bank lending channel is not effective through reserve requirements in China

¨ But this conclusion also stands for changes in other monetary policy measures.

¨ => we tend to support the absence of the bank lending channel in China.


CONCLUSION

¨ 2. Changes in reserve requirements influence loan growth directly

¨ We support the effectiveness of monetary policy through reserve requirements in China.

¨ We obtain the same finding for the other monetary policy instruments.

¨ => Monetary policy is effective through multiple instruments including reserve requirements.


CONCLUSION

¨ 3. The ownership structure of the banking industry influences the transmission of monetary policy

¨ The impact of changes in reserve requirements on loan growth differs across types of banks.


IMPLICATIONS

¨ In terms of instruments: reserve requirements constitute an effective monetary policy instrument that can be used as a substitute to other monetary policy instruments in China.

¨ In terms of channels of transmission: the bank lending channel does not play a major role in the transmission of monetary policy in China.

¨ In terms of banking structure: changes in the ownership structure (privatization, foreign bank entry) can foster or hamper the effectiveness of the monetary policy.


Thanks for your attention.

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