The sequence of bank liberalisation: Financial repression versus capital requirements in Russia

Abstract

In this paper, we highlight one particular aspect of financial repression, namely the presence of high, but lowly compensated reserve requirements. Reserve requirements are widely used as a monetary policy tool aimed at maintaining systemic stability. Typically, compulsory reserves yield a low or even a zero return. In an economy with high inflation, this return is often negative in real terms, causing distorted incentives for asset allocation decisions. When this occurs, reserve requirements become a tool of financial repression. Empirical evidence suggests that countries with high reserve requirements grow slower and have less developed financial systems than countries with low reserve ratios (Haslag and Koo, 1999). Capital rules, on the other hand, have been shown to be able to offset risk behaviour. It therefore appears sensible for the regulator to substitute reserve requirements with capital rules, as she can in this way retain the benefit of increased systemic stability without incurring the cost of financial repression in terms of lower financial development. But first appearances can be deceiving. We model the interaction between reserve requirements, capital rules and banks' risk-taking behaviour in a stylised transition-economy environment. This allows us to assess whether the reduction of financial repression indeed encourages bank gambling and whether the introduction of capital rules mitigates this effect or instead may lead to even more bank gambling.