Involuntary excess reserve and heterogeneous transmission of policy rates to bank lending rates in China

This study examines the impact of liquidity and involuntary excess reserves on interest rate pass-through in China. Employing Error Correction Model estimation based on a sample of 86 banks over the period of 2000-2013, the study finds that liquid banks can better shield against tightening monetary policy and adjust lending rate sluggishly. In contrast, banks with larger involuntary excess reserves tend to increase lending interest rates more rapidly in response to tightening monetary policy. We conclude that unwanted liquidity may lead to risk-taking behaviours which are detrimental to financial stability.