Interbank liquidity and short-term yields in an emerging market economy – the experience of Hungary in 2016–2020

Abstract

Liquidity has an impact on short-term yields, which makes it a key determinant of monetary transmission. The aim of the research was to examine how the increase in the banking system’s liquidity and its distribution within the banking system affects yields. To better understand this relationship, this analysis gives an econometric estimate of the interbank liquidity demand function. The research covers Hungary being a representative of small, open, emerging market economies. The analysis is based on segmented regressions, the study covers the period 2016–2020 regarding overnight interest rates. The slope of the demand function is negative, the coefficients decrease with the increase in excess reserves. The most significant breakpoints of the demand curve are detected around 0.83% and 1.53% of M2 in excess liquidity. There is a correlation between the level of excess reserves and its distribution and concentration. The distribution of liquidity became more balanced along with the increase in excess liquidity. The saturation of the banking system depends on the concentration of liquidity among banks. The results can be useful for other small and open emerging market economies with abundant liquidity, especially in the coming tightening cycle.