Excerpts from speech by Randal Quarles, Vice Chairman for Supervision of the Board of Governors of the Federal Reserve System, at the “Currencies, Capital, and Central Bank Balances: A Policy Conference”, a Hoover Institution Monetary Policy Conference at Stanford University.
Broadly speaking, should the Fed continue to use an operational framework that is characterized by having relatively abundant reserves and operate in what is termed a “floor regime,” or should it use one in which the supply of reserves is managed so that it is much closer to banks’ underlying demand for reserves as in a “corridor regime”?
Of course, a host of complex issues underlie this decision, so I would just like to emphasize two general points. First, a wide range of quantities of reserve balances, and thus overall sizes of the Fed’s balance sheet-could be consistent with either type of framework. Second, while US liquidity regulations likely influence banks’ demand for reserves, the Fed is not constrained by such regulations in deciding its operational framework, because US banks will be readily able to meet their regulatory liquidity requirements using the range of available high-quality liquid assets, of which reserve balances is one type.
Importantly, additional experience with the Federal Reserve’s policy of gradually reducing its balance sheet will help inform policymakers’ future deliberations regarding issues related to the long-run size of the Fed’s balance sheet, issues that will not need to be decided for some time. The final and most general point is simply to underscore the premise with which I began these remarks: Financial regulation and monetary policy are, in important respects, connected.
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In the wake of the crisis, a combination of regulatory reforms and stronger supervision was needed to promote increased resilience in the financial sector. With regard to liquidity, the prudential regulations and supervisory programs implemented by the U.S. banking agencies have resulted in significant improvements in the liquidity positions and in the risk management of our largest institutions. And, working closely with other jurisdictions, we have also implemented global liquidity standards for the first time. These standards seek to limit the effect of short-term outflows and extended overall funding mismatches, thus improving banks’ liquidity resilience.
One particular liquidity requirement for large banking organizations is the LCR, which the US federal banking agencies adopted in 2014. The LCR rule requires covered firms to hold sufficient high-quality liquid assets (HQLA)-in terms of both quantity and quality-to cover potential outflows over a 30-day period of liquidity stress. The LCR rule allows firms to meet this requirement with a range of cash and securities and does not apply a haircut to reserve balances or Treasury securities based on the estimated liquidity value of those instruments in times of stress. Further, firms are required to demonstrate that they can monetize HQLA in a stress event without adversely affecting the firm’s reputation or franchise.
The rules have resulted in some changes in the behavior of large banks and in market dynamics. Large banks have adjusted their funding profiles by shifting to more stable funding sources. Indeed, taken together, the covered banks have reduced their reliance on short-term wholesale funding from about 50 percent of total assets in the years before the financial crisis to about 30 percent in recent years, and they have also reduced their reliance on contingent funding sources. Meanwhile, covered banks have also adjusted their asset profiles, materially increasing their holdings of cash and other highly liquid assets. In fact, these banks’ holdings of HQLA have increased significantly, from low levels at some firms in the lead-up to the crisis to an average of about 15 to 20 percent of total assets today. A sizable portion of these assets currently consists of U.S. central bank reserve balances, in part because reserve balances, unlike other types of highly liquid assets, do not need to be monetized, but also, importantly, because of the conduct of the Fed’s monetary policy, a topic to which I will next turn.
With this backdrop, a relevant question for monetary 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? Let me emphasize that policymakers have long been aware of the potential influence that regulations may have on reserve demand and thus the longer-run size of the Fed’s balance sheet. And, of course, regulatory influences on banks’ behavior, my focus today, is just one of many factors that could affect policymakers’ decisions regarding the appropriate long-run size of the Fed’s balance sheet. In particular, in augmenting its Policy Normalization Principles and Plans, the FOMC stated in June 2017 that it “currently anticipates reducing the quantity of reserve balances, over time, to a level appreciably below that seen in recent years but larger than before the financial crisis” and went on to note that “the level will reflect the banking system’s demand for reserve balances and the Committee’s decisions about how to implement monetary policy most efficiently and effectively in the future.”
As you can see, the current level of reserves, at around $2 trillion, is many orders of magnitude higher than the level that prevailed before the financial crisis, a result of the Fed’s large-scale asset purchase programs that aimed to mitigate the severe economic downturn and stem disinflationary pressures in the wake of the crisis. The vertical lines in the figure show key dates in the implementation of the LCR, including the initial Basel III international introduction of the regulation followed by its two-step introduction in the United States. A key takeaway from this figure is that the Fed was in the process of adding substantial quantities of reserve balances to the banking system while the LCR was being implemented-and these two changes largely happened simultaneously. As a result, banks, in aggregate, are currently using reserve balances to meet a significant portion of their LCR requirements. In addition, because these changes happened together, it is reasonable to conclude that the current environment is likely not very informative about banks’ underlying demand for reserve balances.
But now the situation is changing, albeit very slowly. Last October, the Fed began to gradually and predictably reduce the size of its balance sheet. The Fed is doing so by reinvesting the principal payments it receives on its securities holdings only to the extent that they exceed gradually increasing caps-that is, the Fed is allowing securities to roll off its portfolio each month up to a specific maximum amount. This policy is also reducing reserve balances. So far, after the first seven months of the program, the Fed has shed about $120 billion of its securities holdings, which is a fairly modest amount when compared with the remaining size of its balance sheet. Consequently, the level of reserves in the banking system is still quite abundant.
So, how many more reserve balances can be drained, and how small will the Fed’s balance sheet get? Let me emphasize that this question is highly speculative-policymakers have not decided the desired long-run size of the Fed’s balance sheet, nor, as I noted earlier, do we have a definitive handle on banks’ long-run demand for reserve balances. Indeed, the FOMC has said that it “expects to learn more about the underlying demand for reserves during the process of balance sheet normalization.” Nonetheless, let me spend a little time reflecting on this challenging question.
How banks respond to the Fed’s reduction in reserve balances could, in theory, take a few different forms. One could envision that as the 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, thereby keeping their LCRs roughly unchanged. According to this line of thought, because central bank reserve balances and Treasury securities are treated identically by the LCR, banks should be largely indifferent to holding either asset to meet the regulation. In that case, the reduction in reserves and corresponding increase in Treasury holdings might occur with relatively little adjustment in their relative rates of return. Alternatively, one could argue that banks may have particular preferences about the composition of their liquid assets. And 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 relative asset returns are a key driver of reserve demand, then interest rates across various types of HQLA will adjust on an ongoing basis until banks are satisfied holding the aggregate quantity of reserves that is available.