Liquidity Dependence: Why Shrinking Central Bank Balance Sheets is an Uphill Task
Raghuram Rajan, Katherine Dusak Miller Distinguished Service Professor of Finance
The paper draws on the ideas in our (Rajan and coauthors Rahul Chauhan and Sascha Steffens) theory paper. It finds that when the Federal Reserve expanded its balance sheet via large-scale asset purchases (quantitative easing) in recent years, there is an increase in commercial bank deposits with a shortening of their maturity, and also an increase in outstanding bank lines of credit to corporations. However, when it halted the balance-sheet expansion in 2014 and even reversed it durin gquantitative tightening starting in 2017, there was no commensurate shrinkage of these claims on liquidity. Consequently, the past expansion of the Fed's balance sheet left the financial sector more sensitive to potential liquidity shocks when the Fed started shrinking it, necessitating Fed liquidity provision in September 2019 and again in March 2020. If th epast repeats, the shrinkgage of the central bank balance sheet is not likely to be an entirely benign process and will require careful monitoring of the size of an on- and off-balance-sheet demandable claims on the banking sector.