DP16907 Liquidity, liquidity everywhere, not a drop to use - Why flooding banks with central bank reserves may not expand liquidity

Author(s): Viral V. Acharya, Raghuram G Rajan
Publication Date: January 2022
Date Revised: April 2022
Keyword(s): Capital requirements, central bank balance sheet, Financial Stability, Liquidity dependence, liquidity hoarding, Margin Requirements, Quantitative easing, Repo rate spike
JEL(s): E5, G01, G2
Programme Areas: Financial Economics, Monetary Economics and Fluctuations
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=16907

Central bank balance sheet expansion is financed by commercial banks. It involves not just a substitution of liquid central bank reserves for other assets held by commercial banks, but also a counterpart increase in commercial bank liabilities, such as short-term deposits issued to finance reserves. Banks typically also write a variety of other claims on reserve holdings. Normally, central bank balance sheet expansion will enhance the net future availability of liquidity to the system. However, in episodes of stress when a large fraction of claims on liquidity are exercised, the demand for liquidity can be significantly greater than the availability of reserves. Furthermore, at such times some liquid commercial banks may hoard reserves to bolster their own prospects, contributing significantly to liquidity shortages. Therefore, because central bank balance sheet expansion operates through commercial bank balance sheets, it need not eliminate future episodes of liquidity stress, it may even exacerbate them. This may also attenuate any positive effects of central bank balance sheet expansion on economic activity.