Last week, BPI conducted a survey of its members on why banks hold reserve balances and what can be done to reduce their demand. Survey respondents indicated that the main factors driving their demand were 1) internal risk management practices; 2) passing internal liquidity stress tests; 3) aversion to discount window borrowing and 4) the interest on reserve balances relative to rates on similar assets. Treasurers stated that the three main changes that would be most effective at reducing their demand are: 1) allowing banks to anticipate borrowing from the discount window or Federal Home Loan Banks in their ILSTs; 2) counting discount window capacity toward the liquidity coverage ratio (LCR); 3) reducing discount window stigma.
The Survey
Reserve balances are deposits of insured depository institutions (banks) at one of the 12 Federal Reserve Banks. Reserves represent the Fed’s largest liability and are a critical component of monetary policy implementation. In a nutshell, the Fed can get no smaller than the sum of (i) banks’ demand for reserve balances at the federal funds rate the FOMC wishes to prevail, (ii) the public’s demand for currency, and (iii) the Treasury’s deposit account (the Treasury General Account or TGA). At its December meeting, the FOMC decided to renew growth in its securities portfolio to maintain reserves near their current level of $3 trillion. This decision indicates that the Fed now judges $3 trillion as the amount of reserves it must provide to meet banks’ demand at a fed funds rate in the Committee’s target range of 3½ to 3¾ percent. Before the Global Financial Crisis, banks demanded only $10 billion in reserve balances at the prevailing fed funds rate. What are the drivers of such an increase in the demand for reserves?
That is the question we recently posed to bank treasurers. This note summarizes their answers. The survey asked about 1) the factors determining demand; 2) if the bank had reduced demand over the past two years, why?; and 3) what factors could lead banks to reduce their demand for reserves in the future. There were survey responses from 26 of BPI’s 40 member banks, representing universal banks, trading banks, regional banks and foreign banking organizations.
The BPI survey is intended to supplement the information that the Federal Reserve has collected on these issues in its biannual Survey of Senior Financial Officers (link) by asking about the consequences of regulation and supervision, topics not included in the Fed survey. BPI conducted a similar, although more limited survey in 2019 (link).
The Results
Question 1: Please rate on a scale of 1 (not important) to 5 (very important) the factors that determine the quantity of reserve balances your bank maintains at the Federal Reserve. Please answer “N/A” only if the factor does not apply to your institution.
- Source: BPI Survey. When number of responses does not equal total, some participants answered N/A meaning that factor does not apply to their institution.
As reported above, banks reported several factors that determined their demand for reserve balances. The most important determinant, as stated by nearly all the respondents, is their institution’s assessment of liquidity risk, as opposed to regulations or examiner judgement. While the result suggests that the demand is structural, several banks indicated that the objective of liquidity risk management was, in part, designed to avoid needing to borrow at the discount window or run a daylight overdraft.
The second most important factor cited by banks was passing the internal liquidity stress tests (ILSTs) that large bank holding companies are required to conduct at least monthly. Banks are required to have highly liquid assets (HLA), a category that includes reserve balances, in sufficient quantity to meet their projected cash outflows at the overnight, 30-day, 90-day, and one-year horizons. In a recent speech, “Regulatory Dominance of the Federal Reserve’s Balance Sheet,” Gov. Stephen Miran described how regulation and examination can raise banks demand for reserve balances “…above and beyond what’s required.”
The third most important factor was an aversion to discount window borrowing, closely followed by an aversion to running a daylight overdraft. Reserve balances are essentially funds in each bank’s checking accounts at the Fed. Just as a household may keep extra funds in their checking account to avoid overdrafting, banks keep extra funds in their account to avoid running an overdraft during the day or having to borrow from the Fed to cover an overdraft at the end of the day.
Bank treasurers have consistently reported that their institutions are unwilling to borrow from the discount window, although they have more recently indicated being slightly less unwilling (link). The most important reason treasurers gave for being a bit more willing than previous indications is an FAQ on ILSTs that the Fed published last year. The FAQ stated that banks could point to the discount window, FHLBs, and the Fed’s standing repo operations as the means by which they would monetize a portion of their HLA for all ILST time horizons, and that banks could project cash inflows from borrowing against non-HLA collateral at the discount window for ILSTs beyond the 30-day horizon (i.e. at the 90-day and one-year horizon).
Banks placed some weight on the other factors as determinants of their demand for reserve balances including the position of the IORB rate relative to other market rates (which received the highest importance from banks after the issues noted above), account clearing needs, passing resolution requirements (RLEN and RLAP) and meeting examiner expectations.
For banks that have decreased their reserve balances in the last 2 years, question 2 (results below) asked the reasons for the decline. The only factor in the survey which treasurers gave much weight was that the IORB has declined relative to rates on similar assets. Over the past two years, total reserve balances supplied by the Fed declined from $3.5 trillion to around $3 trillion. As the supply of reserves declined, the overnight repo rate and the fed funds rate rose relative to IORB, making reserves less attractive relative to these alternatives. Given the significant weighting afforded by many banks to the importance of the IORB rate in response to the first question combined with this response to the second question, it is clear that the relative IORB rate will continue to play a significant role in setting the aggregate level of demand for reserve balances.
Question 2: If your bank has reduced the share of assets invested in reserve balances over the past 2 years, why has it done so? Please rate the listed reasons on a scale of 1 (not important) to 5 (very important). Please answer “N/A” only if the factor does not apply to your institution.
- Source: BPI Survey. When number of responses does not equal total, some participants answered N/A meaning that factor does not apply to their institution.
The third question (results below) asked which developments respondents thought would be most effective at reducing their demand for reserves. Most respondents stated that permission to anticipate the ability to use discount window in their ILSTs at any horizon would be effective at reducing their reserve demand, followed closely by the ability to use FHLB borrowing similarly. As stated above, as of August 2024, banks have been allowed to anticipate discount window and FHLB advances as the means by which they would monetization of their HLA collateral, although the Fed still expects banks to demonstrate their capability to monetize such assets in private markets as well. Further, banks can anticipate borrowing from the discount window or the FHLBs against non-HLA collateral at time horizons longer than 30 days (i.e. 90-day and one-year horizon). Non-HLA constitutes two-thirds of the collateral pledged to the discount window.[1] Consequently, being able to anticipate borrowing against such non-HLA collateral at the overnight and 30-day horizons would materially reduce banks’ demand for reserve balances.
The ability to count discount window capacity in the liquidity coverage ratio requirement also ranked highly among the factors that would decrease banks’ demand for reserve balances. Similarly, the ability to count FHLB capacity in the LCR would ease banks demand for holding reserves. The LCR assesses whether banks have a sufficient quantity of liquid assets to meet 30 days of net cash outflows under stress.
Many respondents said that a reduction in the stigma associated with borrowing at the discount window would lead them to reduce their demand for reserve balances. Banks pointed to several developments that could help reduce stigma including, in decreasing order of importance, reduced examiner, equity investor, rating agency and bank management aversion to such borrowing. Several respondents commented that their demand for reserves would not decrease unless stigma from all of these sources was addressed. Some respondents noted that bank management’s aversion to borrowing from the discount window was largely a result of aversion from investors and examiners. Our past discussions with bank treasurers have indicated that congressional and public perceptions of the discount window, in addition to these other factors, also contribute significantly to the stigma associated with usage of the discount window. We’ve previously written on the difficulties with reducing discount window stigma here.
Respondents generally said that reduced standing repo facility stigma would not have a significant impact on their demand for reserves. Many participants noted that they don’t believe there is much stigma at the facility with some noting that they actively borrow at the facility with the goal of reducing stigma.[2]
Banks placed some weight on other factors such as being allowed to anticipate longer discount window use in resolution requirements (RLEN) and reduced examiner preference for reserves, as developments that would reduce their bank’s demand for reserves.
Question 3: Please rate how effective the following would be at reducing your bank’s demand for reserve balances from 1 (not effective) to 5 (very effective). Please answer “N/A” only if the factor does not apply to your institution.
- Source: BPI Survey. When number of responses does not equal total, some participants answered N/A meaning that factor does not apply to their institution.
[1] https://www.federalreserve.gov/monetarypolicy/discount-window-readiness.htm
[2] By contrast, participants at a recent BPI-Morgan Stanley symposium indicated that there was significant stigma associated with standing repo operations. https://bpi.com/bpi-morgan-stanley-symposium-on-money-markets/
