Bank Liquidity and the Transmission of Monetary Policy: Micro-Level Evidence from Indian Banks

This paper examines how bank-level liquidity conditions shape the transmission of monetary policy in a large emerging economy. Using a panel of Indian commercial banks over the period 2005-2020, we test whether liquidity positions influence how banks adjust their lending behaviour in response to policy rate changes. We construct multiple measures of bank liquidity, based on liquid asset holdings, short-term funding dependence, and balance-sheet maturity, and estimate dynamic panel models that allow for bank-specific heterogeneity in the pass-through of monetary policy. Our results show that bank liquidity is a powerful amplifier of the monetary transmission mechanism. Banks with lower liquidity react more strongly to contractionary policy by reducing loan growth, while highly liquid banks are better able to cushion the impact of policy tightening. The asymmetry is economically significant and persists across alternative liquidity definitions, model specifications, and sub-samples. We also find that liquidity interacts with bank size, capitalisation, and ownership to produce differentiated responses to monetary shocks. These findings highlight the importance of liquidity management and prudential regulation in strengthening monetary policy effectiveness, particularly in emerging market banking systems where funding structures vary widely across institutions. The results have implications for liquidity regulation, lender-of-last-resort frameworks, and macro-prudential policy design.