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

66 Pages Posted: 17 Mar 2023

See all articles by Viral V. Acharya

Viral V. Acharya

New York University (NYU) - New York University

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: March 16, 2023

Abstract

When the Federal Reserve (Fed) expanded its balance sheet via quantitative easing (QE), commercial banks financed reserve holdings with deposits 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 weaker-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.

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

JEL Classification: G01, G2, E5

Suggested Citation

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 (March 16, 2023). University of Chicago, Becker Friedman Institute for Economics Working Paper No. 2023-38, Available at SSRN: https://ssrn.com/abstract=4391061 or http://dx.doi.org/10.2139/ssrn.4391061

Viral V. Acharya

New York University (NYU) - New York University ( email )

Rahul Singh Chauhan

University of Chicago - Booth School of Business ( email )

Chicago
United States

Raghuram G. Rajan (Contact Author)

University of Chicago - Booth School of Business ( email )

5807 S. Woodlawn Avenue
Chicago, IL 60637
United States
773-702-4437 (Phone)
773-702-0458 (Fax)

International Monetary Fund (IMF) ( email )

700 19th Street NW
Washington, DC 20431
United States

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States
773-702-9299 (Phone)
773-702-0458 (Fax)

Sascha Steffen

Frankfurt School of Finance & Management ( email )

Adickesallee
32-34
Frankfurt, 60322
Germany
16097326929 (Phone)

HOME PAGE: http://www.sascha-steffen.de

Centre for Economic Policy Research (CEPR) ( email )

London
United Kingdom

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