Liquidity Dependence and the Waxing and Waning of Central Bank Balance Sheets

72 Pages Posted: 11 Oct 2022 Last revised: 28 Mar 2023

See all articles by Viral V. Acharya

Viral V. Acharya

New York University (NYU) - 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)

Rahul Singh Chauhan

University of Chicago - Booth School of Business

Raghuram G. Rajan

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

Sascha Steffen

Frankfurt School of Finance & Management; Centre for Economic Policy Research (CEPR)

Date Written: September 11, 2022

Abstract

When the Federal Reserve (Fed) expanded its balance sheet via quantitative easing (QE), commercial banks financed reserve holdings with deposits, especially uninsured ones, and reduced their average maturity. They also issued lines of credit to corporations. However, when the Fed halted its balance-sheet expansion in 2014 and even reversed it during quantitative tightening (QT) starting in 2017, there was no commensurate shrinkage of these claims on liquidity. Consequently, the financial sector was left more sensitive to potential liquidity shocks, with lower-capitalized banks most exposed. This necessitated Fed liquidity provision in September 2019 and again in March 2020. Liquidity-risk-exposed banks suffered the most drawdowns and the largest stock price declines at the onset of the Covid crisis in March 2020. The evidence suggests that the expansion and shrinkage of central bank balance sheets involves tradeoffs between monetary policy and financial stability, as also evidenced in recent banking stress and runs by uninsured bank depositors.

Keywords: Federal Reserve, quantitative easing, large-scale asset purchases, quantitative tightening, Fed normalization, deposits, lines of credit, financial stability, financial fragility, monetary policy

JEL Classification: G01, G2, E5

Suggested Citation

Acharya, Viral V. and Acharya, Viral V. and Chauhan, Rahul Singh and Rajan, Raghuram G. and Steffen, Sascha, Liquidity Dependence and the Waxing and Waning of Central Bank Balance Sheets (September 11, 2022). Available at SSRN: https://ssrn.com/abstract=4216001 or http://dx.doi.org/10.2139/ssrn.4216001

Viral V. Acharya (Contact Author)

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New York University (NYU) - Department of Finance ( email )

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Rahul Singh Chauhan

University of Chicago - Booth School of Business ( email )

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Raghuram G. Rajan

University of Chicago - Booth School of Business ( email )

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Sascha Steffen

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Centre for Economic Policy Research (CEPR) ( email )

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