Monetary tightening and wholesale funding: What is the implication of bank lending channels on financial stability?

We study how monetary policy affects wholesale funding reliance of the banking sector. Monetary tightening reduces bank retail deposits through three channels: (1) decrease in bank reserves (2) lower money demand (3) substitution to the money market funds. Banks try to attract more wholesale funding in order not to affect their lending, but accessibility to the wholesale funding sources differs across banks. As a result, monetary tightening could increase both reliance and concentration of wholesale funding in the banking sector. We empirically find that prior to the 2007-09 crisis, banks increased their wholesale funding reliance rapidly after the tightening of 2004. Wholesale funding in the banking sector became more concentrated among heavy users after the tightening while the opposite happened prior to the tightening. Our study suggests that new liquidity requirements such as the Liquidity Leverage Ratio (LCR) under the Basel III framework could strengthen the bank lending channel, even for the large banks.  The LCR could bind more during the tightening due to the decrease in the reserves high quality liquid assets (HQLA) and retail deposit outflow (low liquidity risk liability)), but the banks might not be able to as freely tap into alternative funding sources  (wholesale funding) since the LCR treats them differently than retail funding. Thus, the banks would be forced to reduce their lending if monetary tightening drained retail deposits but they could not substitute the lost funding due to the binding LCR. In this case, the bank lending channel is not irrelevant even for the large banks since liquidity requirements bind more for the large ones, and could lead to an aggregate effect on output.