Hard to shift, easy to reshape: central bank reserve demand and frictions
Summary
Focus
How far can central banks shrink their balance sheets? The answer depends on the demand for central bank reserves and in particular on whether the drivers widely believed to have raised it over the past decade actually do. These drivers are: (i) post-Great Financial Crisis (GFC) liquidity regulation; (ii) the difficulty of monetising government bonds into reserves during stress; and (iii) the atrophy of interbank markets after years of abundant reserves. We ask whether these drivers really do shift reserve demand and what this implies for balance sheet normalisation.
Contribution
We build on the canonical model of reserve demand and extend it in three directions to derive how the potential drivers affect the demand for reserves. First, we model the institutional design of the Liquidity Coverage Ratio, which is a requirement on total holdings of high-quality liquid assets rather than on reserves, and we let banks optimise across reserves, government bonds and higher-yielding assets. Second, we allow for monetisation frictions, so that reserves and other liquid assets are imperfect substitutes for meeting payment outflows. Third, we model atrophied interbank markets in which some banks stop participating altogether.
Findings
We find that these frictions generally reshape reserve demand rather than shift it. Liquidity regulation does not raise reserve demand when banks can meet it with other liquid assets. At a certain point along the curve, it reduces demand and lowers the level of reserves at which demand flattens. Monetisation frictions make demand more elastic and raise its satiation level, so that a central bank operating close to this point, for instance with abundant reserves, has to supply more reserves. Fragmentation is different. It breaks the one-to-one link between the reserves the central bank supplies and the money market rate. The effective reserve demand curve also shifts outward in response to negative supply shocks. And the greater the initial level of supply, the larger this shift in demand. Taken together, none of the drivers we discuss prevent central banks from moving back to pre-GFC operational frameworks with scarce levels of reserves.
Abstract
How far can central banks shrink their balance sheets? The answer sets the limits to quantitative tightening (QT), and depends critically on the demand for reserves and whether the drivers widely thought to have increased it over the past decade actually do so. We assess the impact of three such drivers: post-crisis liquidity regulation, monetization frictions, and fragmented interbank markets. Building on the canonical Poole (1968) model, we show that these drivers tend to reshape, rather than horizontally shift, reserve demand. Liquidity regulation, such as the Liquidity Coverage Ratio (LCR), does not raise reserve demand when banks can substitute reserves with other high-quality liquid assets (HQLA). Over some regions of the curve, the LCR even reduces demand. Frictions in monetizing non-reserve HQLA into reserves change both the slope of the reserve demand curve and the satiation point when demand flattens. With fragmented interbank markets, the mapping from aggregate reserve supply to the interbank rate becomes non-unique. In this case, the effective reserve demand curve also shifts outward on impact of negative supply shocks, and the more so, the greater the initial level of supply. These findings have direct implications for balance sheet normalization, especially for central banks operating floor or ample reserves frameworks near the satiation point of the reserve demand curve.
JEL Codes: E41, E43, E52, E58, G21, G28
Keywords: reserve demand, balance sheet normalisation, Liquidity Coverage Ratio, interbank market fragmentation, monetary policy implementation
