How abundant are reserves? Evidence from the wholesale payment system

Summary

Focus 

As central banks start to shrink their balance sheets while tightening policy in response to inflation, the deposit balances of commercial banks ("reserve holdings") are set to shrink as a consequence. Adequate reserve holdings underpin smoothly functioning short-term funding markets, and central banks will need to determine the scope for a smooth reduction in reserves. This paper approaches the issue of adequacy of reserve holdings by gauging how much outgoing payments depend on incoming payments. As reserve balances are the deposits held by commercial banks at the central bank, outgoing payments reduce the reserve balance of the bank making the payment. Delaying payments until incoming payments replenish reserves would conserve reserves. The sensitivity of outgoing payments to incoming payments can therefore serve as a gauge of the value placed by commercial banks on their reserves.

Contribution 

Our results shed light on the appropriate size of central bank balance sheets during monetary tightening and structural shifts in the monetary system. As central banks around the world respond to inflation by raising interest rates and shrinking their balance sheets, the potential consequences for the functioning of short-term funding markets and the wholesale payment system have been a topic of key policy concern. Our findings shed light on the boundaries for the smooth reduction in commercial bank reserve holdings.

Findings 

Before the era of quantitative easing (QE) and large central bank balance sheets which began after the Great Financial Crisis, outgoing payments were typically very dependent on incoming payments, indicating scarce reserves. The surprising finding is that the dependence remains very strong, even in the era of QE and large commercial bank reserves. The evidence comes from Fedwire Funds, the wholesale payment system in the United States operated by the Federal Reserve. A 1% increment in incoming payments by a bank in a 15-minute window is associated with an additional 0.4% of outgoing payments in the subsequent minute.

Abstract

Before the era of large central bank balance sheets, banks relied on incoming payments to fund outgoing payments in order to conserve scarce liquidity. Even in the era of large central bank balance sheets, rather than funding payments with abundant reserve balances, we show that outgoing payments remain highly sensitive to incoming payments. By providing a window on liquidity constraints revealed by payment behavior, our results shed light on thresholds for the adequacy of reserve balances. Our findings are timely, given the ongoing shrinking of central bank balance sheets around the world in response to inflation.

JEL classification: E42, E44, E52, E58, G21

Keywords: real-time gross settlement (RTGS) systems, quantitative tightening, balance sheet management, reserve balances