Experience Stern | Faculty & Research

Shouldn’t the reduction of the size of central bank balance sheets be an entirely benign process – like watching paint dry, as senior Fed officials put it? The central bank will either let bonds held as assets on its balance sheet mature or sell them, thus extinguishing reserves – its liabilities. While bond prices may have to adjust to draw in sufficient private replacement demand, and the swap of bonds for reserves with the private sector may enhance the term premium, these possible price adjustments seem natural consequences to the rebalancing of portfolios. Yet, when the Federal Reserve embarked the last time around on ‘quantitative tightening’, that is, a shrinkage of reserves, financial markets in the US experienced two episodes of significant liquidity stress – in September 2019 and again in March 2020 (by which time the Fed had already restarted injecting reserves). The former episode was attributed in part to significant reserve flows into the Treasury’s Fed account, leaving the private sector short, and in part to the uneven distribution of reserves across banks (e.g. Copeland et al. 2021, D’Avernas and Vandeweyer 2021). The latter episode is attributed to the panic surrounding the COVID-19 outbreak. Notwithstanding the relevance of these proximate causes, we ask whether the prior expansion and then shrinkage of the Fed’s balance sheet had left the private financial sector more vulnerable to such disruptions.

Acharya and Rajan (2022) argue that when the central bank expands its balance sheet, commercial banks, which (typically) have to hold the reserves the central bank issues to finance its asset purchases, tend to finance them with demandable deposits. 1 In part, the desire of banks to match the maturity of assets and liabilities moves them to issue such claims. In part, their enhanced holding of reserves gives banks the confidence they can service any enhanced deposit withdrawals. This is especially the case when reserves are in large supply, for example, during quantitative easing. The reserve holdings become a backstop for commercial banks to issue other fee-generating claims on liquidity, such as lines of credit and other off-balance-sheet commitments to provide financing, that is typically not called upon at the same time as deposits (Kashyap et al. 2002). However, in periods of stress when many claims on liquidity are drawn upon, there is far less ‘spare’ liquidity in the system than might be suggested by the increase in bank holdings of reserves.

What does the evidence say? In Acharya et al. (2022), we analyse data for the period 2008 to 2021, and document (see Figure 1A) that during the initial period of Fed balance sheet expansion – quantitative easing (QE) I from November 2008 to June 2010, QE II from November 2010 to June 2011, and QE III from September 2012 to October 2014 – as well as during the pandemic QE from March 2020, deposits issued and credit lines written by the commercial banks increased. In particular, demand deposits increased while time deposits decreased (see Figure 1B). Importantly, both figures show that bank-written claims on liquidity did not fall significantly when QE ended or when the process of actively shrinking the Fed’s balance sheet during quantitative tightening (QT) started in October 2017; instead, the ratio of demandable claims to reserves increased steeply over these periods. Equally importantly, there was also an expansion of uninsured demand deposits of banks (see Figure 1C), which typically were not held by households. This suggests that bank deposits were not rising simply due to a rise in household assets during QE, implying instead an active role played by banks.

Read the full VoxEU article.

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Viral Acharya is the C.V. Starr Professor of Economics