Analyzing the Relationship Between Monetary Policy and Banking Liquidity and Its Impact on Reducing Banking Distress in Iraq

Abstract

This paper investigates the connection between banking liquidity, monetary policy and their impact on diminishing banking distress in the case of Iraq. The study is descriptive in nature and relies on monetary and banking indicators the Central Bank of Iraq (CBI) releases in special reports, that is, from 2021 to 2024. Monetary policy is proxied by the policy interest rate, reserve requirements, and money supply, while banking liquidity is measured by the credit-to-deposits ratio, liquidity coverage ratio (LCR) and net stable funding ratio (NSFR). Bailout risk is captured by banking distress measured by non-performing loans (NPLs) and financial-stability related variables. The findings show bank liquidity is significantly influenced by monetary policy. Efforts by Iraq's central bank to tighten earlier in the period, and then to relax somewhat in 2024, also supported monetary and financial stability. At the level of the banking sector, the credit-to-deposits ratio rose from 51.9% in 2023 to 59.3% in 2024 and the NPL ratio fell from 7.2% in 2022 to 6.3% in 2023. The liquidity ratios were sustained above the minimum regulatory requirement providing reassurance of adequate liquidity. It is observed that proper liquidity levels together with optimal monetary policy and banking regulation and supervision can lead to a decrease in banking distress (and hence increase in the stability of the Iraqi banking system) which is the highlight of this paper.