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

See all articles by Viral V. Acharya

Viral V. Acharya

Professor; New York University - Leonard N. Stern School of Business; New York University (NYU) - Department of Finance; Centre for Economic Policy Research (CEPR); European Corporate Governance Institute (ECGI); National Bureau of Economic Research (NBER)

Raghuram G. Rajan

University of Chicago - Booth School of Business; International Monetary Fund (IMF); National Bureau of Economic Research (NBER)

Multiple version iconThere are 4 versions of this paper

Date Written: January 2022

Abstract

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

Acharya, Viral V. and Acharya, Viral V. and Rajan, Raghuram G., Liquidity, Liquidity Everywhere, Not a Drop to Use - Why Flooding Banks with Central Bank Reserves May Not Expand Liquidity (January 2022). CEPR Discussion Paper No. DP16907, Available at SSRN: https://ssrn.com/abstract=4026794

Viral V. Acharya (Contact Author)

New York University - Leonard N. Stern School of Business ( email )

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HOME PAGE: http://www.stern.nyu.edu/~vacharya

Professor ( email )

44 West 4th Street
Suite 9-160
New York, NY NY 10012
United States
2129980354 (Phone)
2129954256 (Fax)

HOME PAGE: http://www.stern.nyu.edu/~vacharya

New York University (NYU) - Department of Finance

Stern School of Business
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New York, NY 10012-1126
United States

Centre for Economic Policy Research (CEPR)

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European Corporate Governance Institute (ECGI) ( email )

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National Bureau of Economic Research (NBER)

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Raghuram G. Rajan

University of Chicago - Booth School of Business ( email )

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International Monetary Fund (IMF) ( email )

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National Bureau of Economic Research (NBER)

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