The Macro-prudential aspects of loan-to-deposit-ratio-linked reserve requirement

Micro-prudential regulation is sometimes more focused on the health of the financial institutions and pays less attention to the objective of sustainable intermediation and financial stability in the long run. A macro-prudential policy is formulated to reduce this myopic tendency. This article shows analytically how Loan-to-Deposit-Ratio (LDR)-linked Reserve Requirement (RR) can be used to apply counter-cyclical measures in banking industry by providing disincentive mechanism when a bank operates outside the preferred operational corridor. At the lower limit of LDR, a requirement of higher RR can push banks to extent more loans in order to support economic development in a period of economic bust. At the upper limit of LDR, a requirement of higher RR and/or capital can also provide disincentive to slow down its investment activities in an economic booming period and manage liquidity risk better.