Liquidity, Liquidity Everywhere, Not a Drop to Use - Why Flooding Banks with Central Bank Reserves May Not Expand Liquidity
68 Pages Posted: 4 Feb 2022 Last revised: 27 May 2022
Date Written: January 2022
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. Normally, central bank balance sheet expansion will enhance the net future availability of liquidity to the system. However, in episodes of stress when a large fraction of claims on liquidity are exercised, the demand for liquidity can be significantly greater than the availability of reserves. Furthermore, at such times some liquid commercial banks may hoard reserves to bolster their own prospects, contributing significantly to liquidity shortages. 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 also attenuate any positive effects of central bank balance sheet expansion on economic activity.
Keywords: Capital requirements, central bank balance sheet, Financial Stability, Liquidity dependence, liquidity hoarding, Margin Requirements, Quantitative easing, Repo rate spike
JEL Classification: E5, G01, G2
Suggested Citation: Suggested Citation