The role of liquidity in monetary policy transmission: Evidence from Indian banks1

Abstract

AbstractThe role of bank liquidity in monetary policy transmission has received insufficient attention in the literature. Faced with monetary tightening, banks with more liquidity can sell off securities and protect their loan portfolios. We test this proposition using panel data for Indian banks during 2005–2020. Employing dynamic threshold panel regressions with liquid assets as the threshold variable, we show that bank lending declines with monetary policy tightening in low liquidity regimes, but not in high liquidity regimes. We also find evidence for different portfolio reallocation behaviour by banks in high versus low liquidity regimes in response to monetary policy changes.