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May 04, 2018

Randal K Quarles of the FED spoke at the Hoover Institution Monetary Policy Conference in Stanford, California. He examined the impact of liquidity coverage ratio (LCR) requirements on the FED balance sheet. According to him, the relevant question for policymakers is, “what quantity of central bank reserve balances will banks likely want to hold, and, hence, how might the LCR affect banks' reserve demand and thereby the longer-run size of the FED's balance sheet?”

Mr. Quarles explained that liquidity regulations are a driving factor in the reduction of FED balance sheet. FED was in the process of adding substantial quantities of reserve balances to the banking system while LCR was being implemented—and these two changes largely happened simultaneously. Consequently, banks, in aggregate, are currently using reserve balances to meet a significant portion of their LCR requirements. How banks respond to the FED's reduction in reserve balances could, in theory, take a few different forms, he added. One could envision that as FED reduces its securities holdings, a large share of which consists of Treasury securities, banks would easily replace any reduction in reserve balances with Treasury holdings, thus keeping their LCRs roughly unchanged. Since central bank reserve balances and Treasury securities are treated identically by LCR, banks should be largely indifferent to holding either asset to meet the regulation. Thus, the reduction in reserves and corresponding increase in Treasury holdings might occur with relatively little adjustment in their relative rates of return. One could also argue that banks may have particular preferences about the composition of their liquid assets. Since banks are profit-maximizing entities, they will likely compare rates of return across various HQLA-eligible assets in determining how many reserves to hold. If so, then interest rates across various types of HQLA will adjust until banks are satisfied holding the aggregate quantity of reserves that is available.

He adds that data show the size of the FED's securities portfolio normalizes sometime between 2020 and 2022. He expects banks to continue to increasingly rely on reserve balances, until the normalization of the size of the FED balance sheet. As the balance sheet normalization program continues, FED will be closely monitoring developments for clues about banks' underlying demand for reserves. As reserves continue to be drained, FED will want to gauge how banks are managing their balance sheets in continuing to meet their LCRs, particularly how the distribution of reserve balances across the banking system evolves as well as monitoring any large-scale changes in banks' holdings of other HQLA-eligible assets, including Treasury securities and agency mortgage-backed securities. On the liabilities side of banks' books, FED will be keeping an eye on both the volume and the composition of deposits, as there are reasons why banks may take steps, over time, to hold onto certain types of deposits more than others. Retail deposits may be especially desired by banks going forward because they receive the most favorable treatment under LCR and tend to be relatively low cost. Retail deposits grew quite a bit since the crisis, especially in light of the prolonged period of broad-based low interest rates and accommodative monetary policy, limiting the need for banks to compete for this most stable form of deposits. However, the combination of rising interest rates and the FED's shrinking balance sheet, along with banks' ongoing need to meet LCR, may alter these competitive dynamics.


Related Link: Speech

Keywords: Americas, US, Banking, Liquidity Risk, LCR, HQLA, FED

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