What determines banks' excess demand for reserves?

Focus

The amount of central bank reserves to supply has become a highly contentious policy issue for many central banks that shrink their balance sheets which were built up during quantitative easing. However, there is little evidence about the amount of reserves banks actually want to hold and the factors that shape this choice. To trace bank-level demand for reserves empirically, we exploit new microdata and a unique feature of Sveriges Riksbank's operational framework, under which banks reveal their demand for excess reserves every week. We examine the factors that drive their choice to hold excess reserves, ie to keep reserves at the central bank rather than invest them in other instruments that provide higher returns.

Contribution

Most existing work estimates reserve demand for the banking system as a whole. Bank-level data on reserve holdings and money market trading are rarely available, and central banks tend to adjust the supply of reserves in response to the very forces that shape demand. Our setting avoids both problems: supply is fully elastic, and banks reveal their own demand for excess reserves week by week. Ours is the first study of bank-level factors that shape the demand for reserves, and contributes to the broader policy debate about the size of central bank balance sheets and "demand-driven floors".

Findings

Banks hold substantial excess reserves even though doing so is costly. For banks that participate in interbank markets, excess reserve holdings increase when their payment flows are more volatile and when borrowing from other banks is more expensive. They hold more reserves when activity in the interbank market is lower, consistent with banks relying more on their own liquidity buffers when finding a counterparty is difficult. Banks that do not participate in interbank markets hold particularly persistent reserve balances and also increase them when payment flows become more volatile. By contrast, we find no robust evidence that liquidity regulation increases excess reserve demand. Our results suggest that the functioning and structure of interbank markets are important determinants of aggregate reserve demand. Market fragmentation creates pockets of reserves that are not redistributed, while thin interbank activity can encourage even active banks to hold large precautionary buffers.

Abstract

What determines banks’ demand for holding reserves at the central bank overnight? This has become a critical question for central banks that are shrinking their balance sheets. We exploit the unique operational framework in Sweden and quantify the factors that drive banks’ demand to hold excess reserves at the central bank. Using granular data, we document significant fragmentation in interbank markets with a set of banks that never trade in interbank markets (inactive banks) and others that do (active banks). Active banks’ excess reserves increase with their payment flow volatility and the cost of borrowing in interbank markets. Furthermore, excess reserve holdings shrink when aggregate interbank activity is high. Inactive banks’ excess reserves also increase with their payment flow volatility but show greater persistence over time, underlining their passivity. Our findings not only shed light on the bank-level drivers of excess reserve demand but also on likely dynamics in untested demand-driven floors.