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Liquidity Dependence and the Waxing and Waning of Central Bank Balance Sheets

Author

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  • Acharya, Viral
  • Rajan, Raghuram
  • Steffen, Sascha
  • Chauhan, Rahul

Abstract

When the Federal Reserve (Fed) expanded its balance sheet via quantitative easing (QE), commercial banks financed reserve holdings with deposits and reduced their average maturity. They also issued lines of credit to corporations. However, when the Fed halted its balance-sheet expansion in 2014 and even reversed it during quantitative tightening (QT) starting in 2017, there was no commensurate shrinkage of these claims on liquidity. Consequently, the financial sector was left more sensitive to potential liquidity shocks, with weaker-capitalized banks most exposed. This necessitated Fed liquidity provision in September 2019 and again in March 2020. Liquidity-risk-exposed banks suffered the most drawdowns and the largest stock price declines at the onset of the Covid crisis in March 2020. The evidence suggests that the expansion and shrinkage of central bank balance sheets involves tradeoffs between monetary policy and financial stability.

Suggested Citation

  • Acharya, Viral & Rajan, Raghuram & Steffen, Sascha & Chauhan, Rahul, 2022. "Liquidity Dependence and the Waxing and Waning of Central Bank Balance Sheets," CEPR Discussion Papers 17622, C.E.P.R. Discussion Papers.
    • Handle: RePEc:cpr:ceprdp:17622
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    Cited by:

    1. Chavleishvili, Sulkhan & Kremer, Manfred & Lund-Thomsen, Frederik, 2023. "Quantifying financial stability trade-offs for monetary policy: a quantile VAR approach," Working Paper Series 2833, European Central Bank.
    2. Chavleishvili, Sulkhan & Kremer, Manfred & Lund-Thomsen, Frederik, 2024. "Quantifying financial stability risks for monetary policy," Research Bulletin, European Central Bank, vol. 115.
    3. Bryan Hardy & Sonya Zhu, 2023. "Unpacking international banks' deposit funding," BIS Quarterly Review, Bank for International Settlements, September.

    More about this item

    Keywords

    Monetary policy; Federal Reserve; Quantitative easing; Financial stability; Deposits; Financial fragility; Large-scale asset purchases; Quantitative tightening; Fed normalization; Lines of credit;
    All these keywords.

    JEL classification:

    • E5 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit
    • G01 - Financial Economics - - General - - - Financial Crises
    • G2 - Financial Economics - - Financial Institutions and Services

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