Liquidity, Liquidity Everywhere, Not a Drop to Use: Why Flooding Banks with Central Bank Reserves May Not Expand Liquidity

Central bank balance sheet expansion, through actions like quantitative easing, is run through commercial banks. While this increases liquid central bank reserves held on commercial bank balance sheets, demandable uninsured deposits issued to finance the reserves also increase. Subsequent shrinkage in the central bank balance sheet may entail shrinkage in bank-held reserves without a commensurate reduction in deposit claims. Furthermore, during episodes of liquidity stress, when many claims on liquidity are called, surplus banks may hoard reserves. As a result, central bank balance sheet expansion may create less additional liquidity than typically thought, and indeed, may increase the probability and severity of episodes of liquidity stress.