DP17622 Liquidity Dependence and the Waxing and Waning of Central Bank Balance Sheets
When the Federal Reserve (Fed) expands its balance sheet via quantitative easing (QE), we show commercial banks finance their reserve holdings with demandable deposits, especially uninsured ones, and also issue lines of credit to corporations. These bank-issued claims on liquidity did not shrink when the Fed halted its balance-sheet expansion in 2014 and eventually actively reversed it during quantitative tightening (QT) starting in 2017. Consequently, the financial sector, especially smaller and less-well-capitalized banks that increased their liquidity risk exposure more, became vulnerable to potential liquidity shocks. This in turn has necessitated further liquidity provision by the Fed, as witnessed in September 2019 (repo rate spike), March 2020 (dash for cash due to COVID-19 outbreak), and March 2023 (uninsured depositor runs on banks). The evidence suggests that the expansion and shrinkage of central bank balance sheets leads to liquidity dependence in the financial system, suggesting potential tradeoffs between monetary policy and financial stability.
