Introduction:
Raghuram Rajan, a renowned scholar, presents a thought-provoking analysis on the relationship between central bank balance sheet expansion and liquidity stress in money markets. He emphasizes the significance of understanding the dynamics of commercial bank balance sheets to comprehend the impact of quantitative easing (QE).

QE and the Transformation of Commercial Bank Balance Sheets:

1. Asset Swaps:
When the central bank purchases long-term assets from banks, it replaces them with highly liquid reserves in the banks’ asset portfolios. This asset swap does not necessarily expand the bank’s balance sheet.

2. Expansion of Deposits:
In contrast, when the central bank purchases assets from the public, the commercial bank balance sheet expands. The public deposits the proceeds from the sale of assets with the banks, leading to an increase in deposits.

3. Shift from Time Deposits to Demand Deposits:
Notably, banks tend to finance the acquired liquid assets primarily with demand deposits rather than time deposits. This shift reflects a preference for short-term, uninsured liabilities.

4. Issuance of Lines of Credit:
Banks further extend their claims on liquidity by issuing lines of credit against the reserves they hold. These commitments to provide credit amplify the demand for liquidity.

Implications for Monetary Transmission:

1. Limited Free Liquidity:
The issuance of demand deposits and lines of credit against reserves reduces the amount of free liquidity available in the market. This contradicts the perception that QE creates an abundance of free liquidity.

2. Portfolio Balance View:
The portfolio balance view, which suggests that QE stimulates economic activity by encouraging investment in long-term assets, may not fully account for the offsetting impact of short-term claims issued by banks.

Conclusion:
Raghuram Rajan’s analysis highlights the complex interplay between central bank balance sheet expansion and commercial bank balance sheets. The shift towards demand deposits and the issuance of lines of credit against reserves limit the availability of free liquidity and potentially affect the transmission of monetary policy. Understanding these dynamics is crucial for addressing liquidity stress in money markets and designing effective monetary policies.

QT’s Impact on Bank Balance Sheets:
Selling bonds and buying back reserves during QT does not shrink bank balance sheets as expected. Banks reduce reserves but increase treasury securities, with similar changes occurring in the private non-banking system. Demandable claims on banks remain unchanged during QT, leading to a more fractional reserve system and potential liquidity problems.

Expansion of Demandable Claims:
Post-global financial crisis, banks provide more liquidity than holding assets. They lend to entities, then sell those loans to collateralized loan obligations (CLOs), who hold the loans. Banks offer lines of credit to firms that have borrowed from long-term entities or CLOs, acting as liquidity providers. It’s unclear whether this structure is more efficient or socially valuable.

QE Dependence and Unwinding Challenges:
A large portion of liquidity claims rely on a small base of reserves, increasing reliance on central bank intervention during stress situations. Unwinding QE is difficult due to commercial banks’ reluctance to cooperate. The Fed’s recent establishment of the standing reverse repo facility may provide a temporary buffer before QT directly impacts bank reserves.

Standing Repo Facility and Its Uncertainties:
The Fed created a standing repo facility to allow a wider range of entities to obtain reserves against securities. This facility is untested and carries potential stigma for entities using it, raising concerns about runnable entities and market signals. Its effectiveness and impact on bank behavior are yet to be determined.

Reserve Requirements and Ratchet Nature of QE:
Reserve requirements are not a significant factor in the ratchet nature of QE. The underlying reasons for banks’ resistance to unwinding QE and shrinking their balance sheets remain unclear and require further exploration.

Why Does the Fed’s View Matter?:
Traditional view: Exogenous demand for liquidity leads to the Fed supplying reserves, resulting in zero price for money creation. Rajan’s view: Creating reserves generates new demand from banks writing claims on them, creating a different set of conditions for withdrawal.

Potential Problems with Balance Sheet Expansion:
Difficulty in withdrawing reserves due to increased demand and claims written against them. Interference with monetary policy, particularly when tightening. Financing of the government balance sheet, leading to concerns about monetary financing.

Equilibrium Balance Sheet Size:
Equilibrium size of the balance sheet continues to increase over time due to ongoing issuance of claims on reserves. Potential costs associated with balance sheet expansion, such as political pressures and implications for the price of liquidity.

Banks’ Motivation for Writing Contingent Claims:
Organizational dynamics: Banks maintain relationships with corporations and may be reluctant to withdraw lines of credit even when the Fed tightens monetary policy.

Uncertainties in the Fed’s Approach:
Fed’s increasing propensity for intervention during periods of volatility raises questions about banks’ motivations for writing contingent claims. Complexity in understanding the exact reasons behind banks’ actions.

Organizational Dynamics and the Fed’s Intervention:
Organizational dynamics can incentivize the Fed to intervene, creating a sense of security and encouraging risk-taking in illiquid activities.

QE and Reserves:
QE phases are indicated by vertical lines on the reserve chart. QE1, QE2, and QE3 led to increases in reserves. Reserves drifted down after each QE phase ended, until the Fed began intervening in 2019.

Deposits and Reserves:
Deposits generally follow the trend of reserves, rising during QE phases and flattening during post-QE periods. After QT, deposits declined, but then surged post-2020.

Time Deposits and Demand Deposits:
Time deposits and demand deposits exhibit different patterns. Time deposits show a more pronounced response to QE and QT than demand deposits.

Reverse Repos:
Reverse repos are not covered in the study and only became significant after the liquidity surge in 2020.

Increased Claims on Liquidity:
As QE programs were implemented, claims on liquidity (lines of credit and deposits) relative to reserves increased significantly.

Shift from Time to Demand Deposits:
Banks shifted from issuing time deposits to demand deposits, indicating a preference for cheaper financing options amid excess liquidity.

Uninsured Deposits and Wholesale Funding:
Uninsured demandable deposits, primarily from wholesale entities, surged during QE periods, suggesting banks raised funds to finance treasury holdings.

Active Choice by Banks:
Beyond mechanical factors, banks actively reduced time deposits and expanded lines of credit, indicating intentional choices rather than passive responses.

Diversification of Claims:
Banks issued more demandable deposits and lines of credit to diversify claims on liquidity and earn fees, mitigating risks associated with depositors’ potential simultaneous withdrawals.

Capital Constraints:
While some banks may face capital constraints due to reserve requirements, many are well-capitalized and not subject to such constraints.

Banks Hold Reserves to Meet Liquidity Requirements:
Banks hold reserves to satisfy liquidity regulations, but they must find methods to generate income from these reserves. Creative approaches are used by banks to create claims, such as demand deposits, which can be sold to generate liquidity.

Aggregate Time Series Evidence:
Changes in aggregate reserves are associated with changes in log deposits and lines of credit. Demand deposits increase more than the increase in reserves, while time deposits decrease. The pricing of reserves is influenced by the demand for liquidity created by the reserves.

Pricing of Reserves:
Effective Fed funds rate minus the interest on reserves is a measure of the price of reserves. Without considering deposits, there is a weak correlation between reserves and the price of reserves. Adjusting for deposits reveals a strong negative relationship, indicating that higher reserves lower the price of liquidity.

Panel Data Analysis:
Moving from aggregate time series to a panel analysis provides a more detailed understanding of the relationship between reserves and bank behavior. Higher reserves lead to more demandable deposits issued by banks during QE, but this effect is not reversed after QE. Banks with higher reserves pay lower interest rates on time deposits, suggesting they prefer demandable claims.

Endogeneity of Reserves:
Reserves may be endogenous to particular banks, influenced by factors such as stress levels. An instrument for bank-level reserves is constructed to address endogeneity concerns. The instrument considers aggregate variation in reserves and a bank’s historical utilization of reserves.

Conclusion:
The relationship between reserves and bank behavior is complex and influenced by various factors. Banks actively manage their liquidity positions, seeking to balance regulatory requirements with the need to generate income. A more granular analysis at the bank level provides insights into the nuanced effects of reserves on bank behavior.

Two-Stage Estimation:
We can explain the relationship between reserves and deposits in two stages: reserves influence deposits in demand and savings accounts, and in time deposits.

Demand and Savings Deposits:
More reserves held by banks lead to an increase in demand deposits issued by those banks. Bank characteristics, except for size, do not significantly affect the correlation between reserves and demand and savings deposits.

Time Deposits:
In the pre-QE period, there is a negative correlation between reserves and time deposits, indicating that increased reserves lead to a decrease in time deposits. However, in the post-QE period, this correlation disappears.

Credit Lines:
Similar to demand and savings deposits, an increase in reserves leads to an increase in credit lines issued by banks.

Pricing:
If banks find that holding reserves is the cheapest way to finance their balance sheets, they should shorten the maturity of their liabilities as much as possible.

Term Deposit Pricing:
Banks holding more reserves are less willing to pay interest on term deposits due to their preference for short-term funds to finance the reserves. This behavior leads to a negative correlation between reserves and the term spread, with stronger effects during quantitative easing (QE) but no reversal during quantitative tightening (QT).

Lines of Credit Pricing:
Pricing of lines of credit is measured by the spread between drawn and undrawn lines, representing the cost of liquidity. Similar to term deposits, higher reserves lead to a lower drawn price relative to the undrawn price. This trend is observed during QE episodes but not necessarily during QT.

Liquidity Claims During Reserve Changes:
The question arises as to why banks do not reduce liquidity claims when reserves fall. One possible explanation is that banks engage in asset swaps with the Fed, selling or returning reserves to the Fed in exchange for long-term bonds. However, this strategy relies on the assumption that eligible securities, such as treasuries, can always be used to obtain reserves through repo transactions.

Concerns with Repos:
Repos with other banks do not increase the aggregate supply of reserves, limiting the effectiveness of this approach. Repo transactions with the Fed through the discount window or the statutory repo facility may not be reliable, leading to reliance on repos with other banks. This reliance on interbank repos may result in complacency among banks, assuming they can easily raise funds when needed. However, when banks collectively try to raise money from each other during a crisis, they may find it difficult to meet their liquidity needs.

The Paucity of Reserves:
The repo market may spring out due to a shortage of reserves, leading to a liquidity crunch.

Claims to Eligible Assets Ratio:
The ratio of claims (lines of credit and deposits) to eligible assets plus reserves is increasing, indicating tightening liquidity.

Banks’ Response to Declining Reserves:
Banks may not actively adjust to declining reserves, as they can choose to maintain their desired reserve levels. However, aggregate bank behavior still matters in determining the overall liquidity situation.

Banks’ Active Behavior During QE:
During QE, banks voluntarily issued more claims than necessary, such as moving from time deposits to demand deposits and issuing more lines of credit.

Banks’ Inactivity During QT:
During QT, banks did not reverse the actions taken during QE, leading to a ballooning of claims-to-reserve ratios.

Dispersion in Claims-to-Reserve Ratios:
There is significant dispersion in the claims-to-reserve ratios across banks, with some banks having ratios as high as 52 to 1. Smaller banks typically have higher claims-to-reserve ratios.

Shift in Claims-to-Reserve Ratios Over Time:
The dispersion in claims-to-reserve ratios has increased over time, especially during and after QT.

Bank Size Matters:
Bank size is a key factor influencing banks’ liquidity claims during quantitative easing (QE). Larger banks tend to increase their liquidity claims during QE and reduce them more quickly after QE ends compared to smaller banks.

Organizational Constraints:
Organizational constraints can make it difficult for banks to reduce liquidity claims. These constraints include challenges in withdrawing lines of credit, closing deposit desks, and reducing retail deposits.

Moral Hazard:
Moral hazard may also play a role in banks’ reluctance to reduce liquidity claims. Banks may rely on the Federal Reserve (Fed) to intervene in times of stress, reducing the incentive to manage liquidity effectively.

Consequences of Fed Intervention:
Fed intervention can lead to several consequences. Market underprices liquidity, increasing the need for intervention. The Fed may find it challenging to exit QE due to the system’s tendency to pull it back in.

Financial Activity and Liquidity:
Financial activity during crises often involves speculative activities that require liquidity infusions. Short-term financing drives real activity in such situations, leading to distortions.

Taxation of Liquidity:
Taxing lines of credit, deposits, and demand deposits to curb risky activities has limitations. It is a crude approach that may not effectively target problematic activities. Financial entities with bank-like structures can circumvent such taxes, highlighting the challenges of regulation.

Quantitative Easing (QE):
Rajan expresses skepticism about the benefits of QE, citing significant costs. He advocates for a cautious approach and careful consideration before implementing QE again.

Undoing QE:
Banks are reluctant to reduce their liabilities, even when willing to let go of reserves. Selling bonds and shrinking the balance sheet may not effectively address the issue. Banks may expect continued access to final settlement reserves, perpetuating liquidity issues.

Penalty Rates and Discipline:
Rajan emphasizes the need for penalty rates or mechanisms to restore discipline in financial markets. Central banks must communicate clearly and decisively to avoid sending mixed signals. The Bank of England’s actions in 2022 serve as an example of restoring discipline through temporary intervention.

Monetary Financing:
Rajan cautions against monetary financing, which can send mixed signals when buying long-term assets to reduce long-term rates.

Mixed Signals from the Fed:
The Fed’s balance sheet reduction and interest rate policy appear to contradict each other, sending mixed signals regarding the direction of monetary policy.

Challenges in Implementing Effective Forward Guidance:
Forward guidance, as implemented by the Fed, lacks credibility since it lacks any enforcement mechanisms. The Fed’s attempt to use QE as a signaling tool to communicate its future policy intentions may have delayed the process of tightening monetary policy.

Evaluating the Benefits of QE:
The benefits of QE are often indirect rather than direct, with the primary impact being through bank balance sheets. The direct effects of QE, such as portfolio rebalancing, are unclear and lack strong evidence.

Counterfactual Scenarios:
QE’s impact on the European periphery countries is attributed to bailouts and the resulting increase in bank capital. Alternative approaches, such as directly addressing bank balance sheets, could be more effective than QE.

Discount Window Operations and Systemic Consequences:
Capital infusions to banks during the financial crisis, similar to QE, diffused the cost of the crisis across the entire system, rather than penalizing banks responsible for excessive risk-taking. This approach may set the stage for future liquidity crises if banks are not held accountable for their actions.

Incentives and Moral Hazard:
Raghuram Rajan emphasizes the significance of considering the long-term implications of central bank actions, particularly during crises. He highlights the difficulty of addressing moral hazard during a crisis, as policymakers tend to prioritize resolving the immediate issue and postpone addressing the potential negative consequences.

Unwinding Intellectual and Philosophical Approaches:
Rajan and other speakers discuss the shift away from the traditional discount window approach to resolving liquidity problems. They acknowledge the political and economic factors that influenced this change, including congressional restrictions and the desire to avoid being associated with a collapse.

Deposit Side of Bank Balance Sheets:
Rajan highlights the importance of examining the deposit side of bank balance sheets, which has been overlooked in discussions on liquidity. He notes that central bankers are becoming more cognizant of this issue and are exploring ways to address it.

Concerns about QE and Permanent Liquidity:
Rajan argues that QE should be used as a temporary repair mechanism, not as a permanent solution. He emphasizes the need to re-examine the value of QE and avoid creating permanent liquidity, which can lead to increased demand for liquidity and a ratchet effect.

Supplementary Leverage Ratio:
The supplementary leverage ratio, which imposes a capital charge on reserves and treasuries, is discussed as a potential tool to counter concerns about excessive asset production by banks during quantitative tightening (QT). Rajan suggests that a holistic view of bank balance sheets is necessary to address this issue.

Emergency Liquidity vs. Permanent Liquidity:
Rajan emphasizes the distinction between emergency liquidity, which is provided by central banks to address temporary disruptions, and permanent liquidity, which can lead to unintended consequences. He argues that central banks should focus on providing emergency liquidity rather than creating permanent liquidity.

QE4 and Mortgage-Backed Securities:
Rajan questions the rationale behind the Fed’s purchase of mortgage-backed securities during QE4, given the booming housing market at the time. He highlights the potential risks associated with distorting prices in private markets and the need to revisit the process of QE.

Interest Rate Risk and Costs:
Rajan discusses the interest rate risk taken by the Fed in purchasing long-term assets during QE4, which could result in significant costs to US taxpayers. He emphasizes the importance of considering the implications of rising interest rates on the Fed’s balance sheet and the US government’s debt portfolio.

Undistorting Liquidity:
Rajan responds to objections that permanent liquidity is not inherently bad, arguing that the issue lies in the halfway zone, where liquidity is distorted. He suggests that providing excessive liquidity may not lead to hyperinflation but could result in unintended consequences and undermine the effectiveness of monetary policy.

Key Points:
Infinite Liquidity and Undistorted Prices: The undistorted price is determined under conditions of infinite liquidity. Any deviation from infinite liquidity introduces distortions in pricing. Treasury Debt Management and Distortions: The Treasury’s issuance of long-term debt instead of short-term debt and lack of understanding of swaps have contributed to distortions in pricing. This issue can be resolved by offering reserves in unlimited quantity by the Treasury. Government Activity and the Fed’s Balance Sheet: The size of the Fed’s balance sheet can influence government activity. The costs and implications of a large Fed balance sheet on government activity need to be debated. Debate Postponed: The speaker proposes to continue the discussion on the costs of a large Fed balance sheet and the Treasury’s debt management issues in a separate conversation.