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

When the Federal Reserve (Fed) expanded its balance sheet via quantitative easing (QE), commercial banks typically financed reserve holdings with uninsured demandable deposits. They also issued credit lines to corporations. In the aggregate, these bank-issued claims on liquidity did not shrink commensurately when the Fed halted QE and turned to quantitative tightening (QT). Consequently, banks that increased liquidity risk exposure – especially small and regional banks – became vulnerable to liquidity shocks, necessitating further liquidity provision by the Fed. The evidence suggests that the expansion and shrinkage of central bank balance sheets has led to liquidity dependence of banks on central banks.