Reserves Were Not so Ample after All

Abstract

The Federal Reserve's "balance-sheet normalization," which reduced aggregate reserves between 2017 and September 2019, increased repo rate distortions, the severity of rate spikes, and intraday payment timing stresses, culminating with a significant disruption in Treasury repo markets in mid-September 2019. We show that repo rates rose above efficient-market levels when the total reserve balances held at the Federal Reserve by the largest repo-active bank holding companies declined and that repo rate spikes are strongly associated with delayed intraday payments of reserves to these large bank holding companies. Intraday payment timing stresses are magnified by early-morning settlement of Treasury security issuances. Substantially higher aggregate levels of reserves than existed in the period leading up to September 2019 would likely have eliminated most or all of these payment timing stresses and repo rate spikes.

Dynamic Banking and the Value of Deposits

“…Undercapitalized banks demand safe assets because deposits serve as means of payments and the uncertainty in payment flows translates into deposit risk. Copeland, Duffie, and Yang (2021) provide recent evidence on such safe-asset demand of banks. Our model shows that the demand is particularly strong in crises when banks are undercapitalized and close to violating the SLR requirement.…”

“…In static settings, the literature explores the implications of payment risk on banks' liquidity holdings and incentive to lend(Freixas, Parigi, and Rochet, 2000;Donaldson, Piacentino, and Thakor, 2018;Parlour, Rajan, and Walden, 2020). Empirically, banks face large payment flow shocks(Furfine, 2000;Bech and Garratt, 2003;Afonso and Shin, 2011;Denbee, Julliard, Li, and Yuan, 2018;Choudhary and Limodio, 2017;Copeland, Duffie, and Yang, 2021).5 While our model introduces the costs of issuing equity(Myers and Majluf, 1984), the link between equity and…”

“…This specification of slow-moving deposits captures the well-documented inertia in depositors' decisions to switch banks(Kim, Kliger, and Vale, 2003) and broadly banks' deposit market power(Drechsler, Savov, and Schnabl, 2017).11Freixas, Parigi, and Rochet (2000),Bianchi and Bigio (2014),Donaldson, Piacentino, and Thakor (2018), and Parlour, Rajan, and Walden (2020) study deposits as both banks' sources of funds and depositors' means of payment.12 The values of δ X and σ X depend on the bank's position is in payment networks. The payment flow risk is significant in data(Afonso and Shin, 2011;Denbee, Julliard, Li, and Yuan, 2018;Copeland, Duffie, and Yang, 2021).…”