NY Fed: reserve balances increasingly used for short-term funding operations

Before the era of large central bank balance sheets, banks relied on incoming payments to fund outgoing payments in order to conserve scarce liquidity. Even in the era of large central bank balance sheets, rather than funding payments with abundant reserve balances, we show that outgoing payments remain highly sensitive to incoming payments. Staff researchers from the New York Federal Reserve provide a window on liquidity constraints revealed by payment behavior, and the results shed light on thresholds for the adequacy of reserve balances.

Even in the post-global financial crisis (GFC) era of ample reserves, the payment timing decisions of banks in the US wholesale real-time gross settlement (RTGS) system suggest that access to central-bank reserve balances is a constraint on funding liquidity. The researchers find strong evidence that US banks still economize on intraday liquidity. They rely on incoming payments to make outgoing payments, showing a 18 high degree of strategic complementarity in their payment decisions. These results persist despite large aggregate reserves balances in the banking system, well in excess of the aggregate balances prior to the GFC.

The results shed light into the ongoing discussion of the sizing of central bank balance sheets and the shifting nature of banks’ demand for reserves. As central banks around the world respond to inflation by tightening their monetary stance and shrinking their balance sheets, the potential consequences for the wholesale payment system of the ongoing draining by central banks of reserves will likely be an important input into policy making.

The findings also show that the strength of the strategic complementarity of payment timing varies with the level of aggregate reserves, becoming stronger as aggregate reserve balances decline. This suggests a potential for strategic cash hoarding when reserve balances get sufficiently low, as was the case in mid-September 2019 and mid-March 2020. A shift in the business models of banks has led reserve balances to be used increasingly for short-term funding operations, including the intermediation of FX swap markets, Treasury repo markets, and other short-term funding markets. The shrinking supply of reserve balances may come to have potentially important implications for market functioning and financial stability.

The full report is available at https://www.newyorkfed.org/medialibrary/media/research/staff_reports/sr1040.pdf

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