Banks play a key role in modern economies. They facilitate trade, economic growth and help protect idle money against inflation.

These and other benefits have long led economists to view banks as welfare-improving institutions. 

However, a recent study by Associate Professor Timothy Kam (ANU Research School of Economics) and CBE alumnus Sam Ng suggests certain stances in monetary policy and prudential regulation can undermine these gains.

The research identifies a new policy mechanism and interactions between three key elements crucial to monetary policy and banking regulation:

1) Banking: a role of banks as systems that take deposits of money and provide loans to those who need it. The ANU model intentionally considers the idealised case of a perfectly competitive banking sector.

2) Endogenous retail market power and markups distribution: the ability of firms to manipulate the price of an item in the marketplace, with a resulting dispersion in price markups that is sensitive to policy and market forces.

3) Reserve requirement regulation: rules mandating banks to hold a minimum level of liquid assets to protect them against bank runs. They are set by a country’s central bank or prudential regulator and can be binding or non-binding.

“When reserve requirements are binding, and in conjunction with a certain range of inflation targets set by monetary policy, increased access to credit can unintentionally strengthen firms' market power in the retail industry – leading to higher prices and reduced economic welfare,” says Kam.

Policymakers attempting to promote greater banking competition should consider potential pecuniary externalities

When reserve requirement regulations on banks are legally binding, they generate a gap between loan and deposit rates.

As borrowing becomes more costly, a larger amount of consumers avoid using bank credit.

At the same time, sellers anticipate that some buyers still have access to credit and are able to pay more. In response, they adjust their pricing behaviour, leading to price dispersion: some consumers face higher prices than others.

This, in turn, affects consumption across the economy, disproportionately burdening buyers who do not use bank credit.

“This channel running from the use of banking to potentially harm retail consumer welfare is what we call a negative pecuniary externality (of credit) . Credit-fuelled spending by some buyers drives up prices for all, reducing welfare for non-borrowers and exacerbating inequality in purchasing power,” says Kam.

“As a result, the primary benefit of banking –helping to insure individual liquidity risks – gets overwhelmed by goods retailers extracting consumer welfare.”

Notably, the research shows that these adverse effects can occur even when there is perfect competition among banks – an idealised scenario.

“In a real economy, pecuniary externalities are likely to be larger,” says Kam.

Paying interest on bank reserves could help reduce externalities

Kam argues that providing banks with a return on their required reserves may help relax their reserve regulation constraint, thereby reducing externalities on consumers.

“Paying interest on reserves can complement the long-run, inflation-targeting policies that central banks traditionally employ to stabilise prices, ultimately enhancing overall economic welfare,” he explains.

Overall, the CBE study offers important insights with clear implications for monetary policy design.

“Access to bank credit creates winners and losers. When reserve requirements bind, lending can unintentionally strengthen firms’ power to raise prices,” Kam says.

“Policymakers should aim to identify and quantify these externalities to ensure banking regulation and competition policy support, rather than undermine, consumers. Careful coordination between monetary policy and prudential reserve regulation matters for avoiding such externalities on consumers.”