The Liquidity Central Banks May No Longer Be Able to Withdraw
Banks have become structurally dependent on abundant reserves. Quantitative tightening is revealing that “normal” monetary policy may no longer have a clear destination.
Central banks describe quantitative tightening as normalisation.
The language suggests a return journey: balance sheets expanded during exceptional crises, liquidity became extraordinarily abundant and now the system can gradually return to its previous condition.
But return to what?
The banking system of today is not the banking system that existed before quantitative easing. Regulation has changed, payment systems have accelerated, deposits have become more mobile and banks have reorganised liquidity management around the presence of vast central-bank reserves.
The destination of normalisation is therefore unknown.
A recent Bank for International Settlements working paper examines what determines banks’ excess demand for reserves. The question sounds technical, but its implications are profound.
If banks now require structurally larger reserve balances, central banks may be unable to shrink their balance sheets as far as expected without destabilising money markets. The temporary legacy of crisis intervention may have become a permanent feature of modern banking.
Reserves are not ordinary cash
Central-bank reserves are electronic balances held by commercial banks at the central bank. They are used for settlement, payments and compliance with liquidity requirements.
Only financial institutions with access to the central bank can normally hold them. They are not the same as banknotes, customer deposits or money that banks directly lend to households.
When central banks conduct quantitative easing, they purchase securities and credit the banking system with reserves. The aggregate volume of reserves increases, even though individual banks can redistribute those balances among themselves.
After years of asset purchases, banks adapted to abundant reserves. Liquidity management became easier, intraday payment risks declined and reliance on unsecured interbank funding diminished.