Liquidity, Liquidity Everywhere, Not a Drop to Use - Why Flooding Banks with Central Bank Reserves May Not Expand Liquidity
63 Pages Posted: 11 Jan 2022 Last revised: 6 Sep 2022
Date Written: November 11, 2021
Central bank balance sheet expansion is financed by commercial banks. It involves not just a substitution of liquid central bank reserves for other assets held by commercial banks, but also a counterpart increase in commercial bank liabilities, such as short-term deposits issued to finance reserves. Banks typically also write a variety of other claims on reserve holdings. These claims reduce the net future availability of liquidity to the system, dampening the normal effect of reserves in improving liquidity. In episodes of stress when a large fraction of claims on liquidity are exercised, the demand for liquidity can even exceed available reserves, made scarcer due to hoarding by some liquid commercial banks. Therefore, because central bank balance sheet expansion operates through commercial bank balance sheets, it need not eliminate future episodes of liquidity stress, it may even exacerbate them. This may attenuate any positive monetary effects of reserve expansion on economic activity.
Keywords: Quantitative easing, Central bank balance sheet, Financial stability, Repo rate spike, Liquidity hoarding, Liquidity dependence, Margin requirements, Capital requirements
JEL Classification: G01, G2, E5
Suggested Citation: Suggested Citation