In the panic of 1907, a son of Italian immigrants turned American bank executive highlighted a truism of global finance. Having stockpiled liquid assets ahead of potential financial turmoil, Amadeo Giannini stemmed a run on his bank by displaying his bulked-up gold reserves to a nervous public, offering to convert customers' deposits into the precious metal at a time when other banks were refusing to do the same.
It was a move that insulated Bank of Italy, later to be renamed Bank of America Corp., from much market mayhem at the time and demonstrated the importance of maintaining liquid buffers in the financial system—an importance that was arguably forgotten in the runup to the recent financial crisis. In the years before 2008, reserves held at large U.K. banks had drifted from around 30 percent of their total assets to a mere 1 percent, for instance.
Seven years after the crisis, reserves and high-quality assets required to be held by banks to cover potential funding outflows are still being built up through the introduction of new financial regulation, with far reaching consequences. A new paper by Zoltan Pozsar, director of U.S. economics at Credit Suisse AG, underscores the complex interplay between new banking regulation and the role of the Federal Reserve in financial markets, arguing that the existence of these new liquidity requirements may force the U.S. central bank to revamp itself into a new global funding force.
Indeed, the Fed's bloated balance sheet may prove to be its permanent state rather than a temporary phenomenon in the aftermath of years of stimulative monetary policy, he says.
In the wake of the financial crisis, the Fed's monetary policy toolbox evolved to provide additional stimulus to an economy reeling from negative shocks. New measures—namely, asset purchases known as quantitative easing—were used to support the economy. Novel steps have also been taken to begin to withdraw this accommodation.
Due to the magnitude of the excess reserves in the banking system—a legacy of the Fed's large-scale asset purchases—traditional open-market operations to adjust the so-called federal funds rate (FF) were viewed as insufficient. As such, the central bank has made use of overnight reverse repurchase agreements, a tool dubbed the Death Star, to further drain liquidity from the financial system.
"Big is not odd; small was odd," Pozsar writes. "Instead of asking when the Fed will shrink its balance sheet, it's about time the market gets used to the idea that we are witnessing a structural shift in the amount of reserves the U.S. banks will be required to hold, where reserves replace bonds as the primary source of banks' liquidity. And that this shift will underwrite demand for a large Fed balance sheet."
In some respects, a big central bank balance sheet may represent a return to normality. Had regulators asked banks to hold an extra $50 billion in reserves every year from 1971 onwards to coincide with the explosion in wholesale (repo) funding markets, Pozsar says, the Fed's balance sheet would look roughly like it does now.
Source: Credit Suisse
