The Liquidity Central Banks May No Longer Be Able to Withdraw

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.

What central banks presented as emergency liquidity gradually became part of the system’s operating architecture.

“Excess” does not necessarily mean unnecessary

The word “excess” creates the impression that these reserves are idle or redundant.

That conclusion is misleading.

A reserve balance can exceed formal minimum requirements while remaining operationally valuable. Banks use additional reserves as protection against payment shocks, deposit outflows, market volatility and uncertainty concerning their daily liquidity position.

Regulatory requirements introduced after the global financial crisis also increased the value of high-quality liquid assets. Central-bank reserves are the most liquid asset available.

Banks therefore do not assess reserves solely according to their statutory minimum. They consider internal risk limits, supervisory expectations, stress scenarios, payment flows and the potential reputational consequences of approaching central-bank facilities.

The demand for reserves is partly legal, partly operational and partly psychological.

The stigma surrounding central-bank borrowing

In theory, a bank facing an unexpected liquidity shortage can borrow from the central bank.

In practice, institutions may fear that using emergency or standing facilities will be interpreted as evidence of weakness. Even if borrowing is economically rational, markets, counterparties and supervisors may draw negative conclusions.

This stigma increases precautionary demand for reserves.

A bank may prefer to hold a larger liquidity buffer permanently rather than risk being forced to request central-bank funding at the wrong moment.

The paradox is clear: central banks create lending facilities to reduce banks’ need for precautionary reserves, but the perceived stigma attached to those facilities can encourage banks to hold even more reserves.

Regulation changed the monetary landscape

Post-2008 reforms were designed to make banks safer. The Liquidity Coverage Ratio requires institutions to hold sufficient high-quality liquid assets to withstand a severe short-term outflow scenario.

That objective is sensible.

But regulations interact with monetary operations. When reserves are abundant and remunerated, they become an attractive way to satisfy liquidity needs. Banks reorganise their balance sheets accordingly.

Removing reserves later is not neutral. Institutions must replace them with other liquid assets, reduce balance-sheet activity or obtain funding elsewhere.

The process can affect government-bond markets, bank lending and short-term interest rates.

A central bank may therefore discover that the banking system’s demand curve for reserves becomes very steep before the balance sheet returns anywhere near its pre-QE size.

At that point, a relatively small additional reduction in reserves can produce a disproportionate increase in money-market volatility.

September 2019 was a warning

The disruption in the US repo market in September 2019 demonstrated how quickly apparently abundant liquidity can become scarce.

Short-term borrowing rates surged despite the banking system holding a historically large volume of reserves. The aggregate number appeared comfortable, but the distribution of liquidity, regulatory constraints and settlement flows prevented reserves from moving smoothly to where they were needed.

The Federal Reserve was forced to intervene.

The lesson was not simply that the Fed had withdrawn too much liquidity. It was that nobody knew with confidence where the scarcity threshold was located.

Aggregate liquidity is not the same as usable liquidity. Reserves can be concentrated among institutions unwilling or unable to lend them. Balance-sheet constraints can obstruct arbitrage precisely when it is most necessary.

Quantitative tightening is not the reverse of quantitative easing

Central banks frequently communicate balance-sheet reduction as the mechanical opposite of asset purchases.

It is not.

During QE, the central bank creates reserves and buys securities. During QT, securities mature or are sold, and reserves decline. But the financial system’s reaction is path-dependent.

QE changes asset prices, collateral availability, bank behaviour and market structure. Institutions build businesses and risk-management systems around the new environment.

Reversing the accounting transaction does not automatically reverse these structural changes.

Moreover, the liabilities of a central-bank balance sheet include more than bank reserves. Currency demand, government deposits and other autonomous factors can affect how quickly reserves decline.

A central bank may reduce its assets gradually while usable banking-system liquidity contracts more rapidly than expected.

Abundant reserves create political consequences

Large central-bank balance sheets are not only monetary instruments. They also have fiscal and political effects.

When central banks pay interest on reserves, higher policy rates can produce substantial payments to commercial banks. These payments are economically connected to the cost of implementing monetary policy, but they are politically difficult to explain.

Governments may see central-bank losses or reduced remittances to the treasury while banks receive interest on reserve balances.

Critics then ask why public institutions are paying banks to hold money created through previous asset purchases.

The simplistic answer is that central banks should stop remunerating reserves. But eliminating remuneration could weaken control over short-term rates, encourage destabilising portfolio shifts and fundamentally alter the operating framework.

The system has become technically coherent but politically vulnerable.

Have central banks partially nationalised the money market?

Before the era of abundant reserves, banks relied more heavily on interbank markets to redistribute liquidity. Central banks supplied a scarcer settlement asset and influenced the overnight rate through relatively limited interventions.

Under a floor system with abundant remunerated reserves, the central bank becomes a much larger counterparty to the financial system. Its administered deposit rate establishes the floor beneath money-market rates.

This provides control and stability, but it also reduces the role of private interbank price discovery.

The modern money market increasingly operates around the central bank’s balance sheet.

This does not mean commercial banking has been nationalised. It does mean that the state’s monetary authority occupies a structurally larger position inside the system.

What began as emergency support has evolved into a new monetary regime.

The danger lies near the invisible threshold

Central banks can reduce reserves without immediate consequences as long as liquidity remains comfortably abundant.

The problem begins when the system approaches the point between abundance and scarcity.

That threshold cannot be measured precisely in advance. It changes with deposit behaviour, regulation, market concentration, payment technology and perceptions of risk.

Once crossed, the consequences can appear suddenly: repo-market pressure, increased competition for deposits, forced asset sales, reduced credit or emergency borrowing from central-bank facilities.

The system can move from “too much liquidity” to “not enough usable liquidity” faster than policymakers expect.

There may be no return to the old normal

This is the central conclusion that policymakers are reluctant to state clearly.

Balance sheets can become smaller. Quantitative tightening can continue. But the reserve supply compatible with stable markets may remain far above its pre-crisis level.

The old framework depended on scarcity. The new framework depends on abundance.

Central banks must decide whether to accept permanently large balance sheets, develop stronger facilities capable of supplying liquidity without stigma, or redesign the regulatory and operational structure surrounding reserves.

None of these choices is costless.

The debate is not about whether banks have become addicted to free money. Reserves are not free, and their functions are more complex than that slogan implies.

The real issue is institutional dependence. Central banks transformed the financial system to survive repeated crises. The system adapted successfully—and may now be unable to function safely without the architecture created during those emergencies.

Quantitative easing was introduced as exceptional policy. Abundant reserves may be its permanent legacy.

Sources

• BIS Working Paper No. 1376 — What determines banks’ excess demand for reserves?⁠

• Federal Reserve — Monetary Policy Report⁠

• Federal Reserve Bank of New York — The Repo Market Events of September 2019⁠

• Bank for International Settlements — Committee on the Global Financial System⁠

• European Central Bank — Monetary-policy instruments and operational framework⁠

Roberto Balbino — CEO, Fintech SCB
International Finance & Banking Executive | Independent Analyst of Finance, Economics, Geopolitics & Global Markets