• Sun. Jul 14th, 2024

How much cash should be removed from the financial system?

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The world is still, in a sense, swimming in cash. Or at least the electronic equivalent: central-bank reserves. The Bank for International Settlements (BIS), a club of central banks, estimates that the balance-sheets of rich-country central banks amount to roughly 50% of collective GDP. That is down from 70% in 2021—a reduction which reflects quantitative tightening (QT), or the offloading of assets acquired while easing—but is still far above the pre-global-financial-crisis norm of around 10%.

Qt is intended to enhance the disinflationary effect of raising interest rates. As assets roll off a central bank’s balance-sheet, the corresponding reserves are extinguished. The process should, in the words of Janet Yellen, America’s treasury secretary and a former chair of the Federal Reserve, be as interesting as watching paint dry. Yet if reserves are to return to anything like their earlier 10% level, that may not be the case. Some worry such a reduction would prompt nasty surprises in the financial system. Hawkish types nevertheless argue that central banks ought to ensure reserves once again become “scarce”. They suggest that the “abundant” era created by quantitative easing has been destabilising, since banks no longer need to economise on their holdings or rely on the disciplining effects of money markets.

Commercial banks want to hold central-bank reserves for two reasons: to carry out transactions with one another and as a precaution in case things go wrong. Both reasons have become more pressing since the financial crisis. Banks are bigger and do more business; regulators have imposed stricter capital requirements. Moreover, the failure of Silicon Valley Bank last year showed that bank runs can be accelerated by digital communication. The Bank of England (BoE) now says that its preferred level of reserves in the British banking system is more or less double in cash terms what it was before the covid-19 pandemic.

Even so, the supply of reserves is still outstripping demand. Banks have to be willing to hold these abundant reserves at the prevailing interest rate. Modelling by David Lopez-Salido and Annette Vissing-Jorgensen, both of the Fed, finds that demand for reserves depends on a combination of the level of commercial-bank deposits and the spread between the rate that can be earned from lending in the money markets and the interest rate on reserves paid by the Fed. Owing to the surplus of reserves in the system, the interbank money market—in which banks lend reserves to one another—is moribund, offering barely, if anything, above the rate offered by central banks. Policymakers have therefore become borrowers of first resort, draining liquidity from the economy by offering a higher return than commercial alternatives.

So far this has not caused problems. Central banks have demonstrated over the past few years that they are able to use interest on reserves as a tool to tighten monetary policy. Regular payouts to banks may have been an annoyance for finance ministries, which own central bankers’ profits and losses, but central banks exist to manage the economy, not to provide dividends to their shareholders. Critics contend, however, that this stability is illusory. Claudio Borio of the BIS is among those arguing that central banks should move back to a scarce reserve system. Their ability to secure liquidity would, for the first time in decades, have to be routinely tested in the money markets. That would be good, he has said: “If you don’t use a muscle, it atrophies.”

This atrophy was evident in September 2019, when the cost of American repo transactions, in which banks and others temporarily swap high-quality assets for reserves, suddenly spiked as corporate-tax payments and the settlement of some government debt coincided, raising demand for cash. The money market, where a small number of participants tend to trade similar volumes every day, was not capable of dealing with the sudden surge, meaning that the cost of borrowing spiked. The Fed had to put the brakes on QT that was then taking place, since reserves had turned out to be scarcer than thought.

Yet there are problems with the idea that a scarce reserve system is safer than an abundant one. Although advocates of a scarce system argue that, in such a system, money markets would monitor banks’ creditworthiness and disseminate such information, market signals failed to flash warnings over excesses before the financial crisis. Nor did wholesale markets distinguish between institutions when the crisis hit. Banks with strong reputations found themselves frozen out alongside their shakier peers.

Threading the needle

Populist politicians are beginning to grouse more loudly about the subsidy for commercial banks inherent in the current system. For their part, central banks are now investigating hybrid approaches. The Fed wishes to move from an “abundant” system to what it calls an “ample” one, where changes to the volume of reserves have a small impact on their price. Under such a system, commercial banks would occasionally, but not always, rely on money markets. The Fed introduced a standing repo facility after the ructions of 2019, which sets a ceiling on the interbank rate. It is little used and intended as a backstop in case of emergencies.

Isabel Schnabel of the European Central Bank has eschewed the abundant-scarce framing and instead called for a move from a “supply-led” system to a “demand-led” one. Reserves would be determined by the appetite of commercial banks, at an interest rate set by the central bank via a weekly repo facility, its main refinancing operation. That should, she said, ensure the “smooth implementation of monetary policy”. Andrew Bailey of the BoE has also touted a newish short-term repo facility. Under their approach, the world would still swim in cash, but it would be commercial rather than central banks in control of the hosepipe.

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