…the financial sector vulnerabilities are revealed
In this paper Acharaya et al. argue that during periods of QE, the financial sector generates substantial potential claims on liquidity, effectively eating up much of the issued reserves. The quantity of spare liquidity is thus much smaller than that of issued reserves, which can become a big problem in the event of a shock, such as a government-induced scare, as it recently happened in the UK. In the U.S., QT makes conditions even tighter, because the financial sector does not quickly shrink the claims that it has issued on liquidity, even as the central bank takes back reserves.
We argue that this asymmetric behavior makes the banking system dependent on the central bank for ever larger liquidity infusions during stress and can explain tightening liquidity conditions and occasional stress episodes when quantitative tightening is underway, despite the central bank balance-sheet being large relative to historical standards. Quantitative tightening may therefore not be as benign or painless for the financial sector and the economy as quantitative easing. This also implies reserve expansion may have muted, even adverse, effects on available liquidity and thence financial stability, with greatest vulnerability when reserves are shrunk.
Liquidity Dependence: Why Shrinking Central Bank Balance Sheets is an Uphill Task
Authors: Viral V Acharya, Rahul S Chauhan, Raghuram Rajan, Sascha Steffen
From: NYU Stern School of Business, University of Chicago Booth School of
Business, Frankfurt School of Finance
The 2020 liquidity shock in the U.S.
The open-end investment funds (OEFs) are mutual funds that can issue or redeem shares daily at a price set at the end of the trading day. Since the global financial crisis OEFs have become an important component of the nonbank financial sector as they reached $41 trillion in the first quarter of 2022. But the OEFs that offer daily redemptions while holding illiquid assets can amplify the effects of adverse shocks by raising the likelihood of investor runs and asset fire sales. This contributes to volatility in asset markets and potentially threatens financial stability.
In March 2020, amid heightened uncertainty about the economic outlook, OEFs that were invested in relatively less liquid assets experienced historic outflows and a “dash for cash” at the onset of the COVID-19 pandemic. This contributed to market dislocations and liquidity problems that were resolved only after central banks flooded the system with reserves.
Asset Price Fragility in Times of Stress: The Role of Open-End Investment Funds
From: IMF
