Academic journal article Federal Reserve Bank of St. Louis Review

How Have Banks Been Managing the Composition of High-Quality Liquid Assets?

Academic journal article Federal Reserve Bank of St. Louis Review

How Have Banks Been Managing the Composition of High-Quality Liquid Assets?

Article excerpt

1 INTRODUCTION

Liquidity management--ensuring access to sufficient quantities of assets that can be converted easily and quickly into cash with little or no loss of value--has always been a key component of banks' balance sheet management. However, liquidity management has become an even more important consideration in banks' operations in the wake of the Global Financial Crisis of 2007-09 with the introduction of new regulations aimed at ensuring banks' ability to meet their cash and collateral obligations during times of financial stress. In particular, beginning in 2015, large banks in the United States have needed to comply with the liquidity coverage ratio (LCR) by holding sufficient "high-quality liquid assets" (HQLA), a requirement that has induced significant changes to banks' balance sheet management. In this article, we examine how U.S. banks have managed the composition of their HQLA to meet the LCR and other liquidity considerations over the past several years. (1) In particular, we address the following questions: Which particular liquid assets have banks chosen to hold and in what shares? Have those liquid shares changed over time? Do banks' preferences for these liquid shares vary? If so, what factors may be driving banks' preferences in this regard?

Understanding banks' liquidity management is central to both the implementation and the transmission of monetary policy. Banks' preferences regarding the compositions of their liquid pools--and in particular their demand for excess reserve balances--interact with various short-term market interest rates and thus the Federal Reserve's setting of its administered rates. In turn, the constellation of these interest rates affects banks' choices regarding the composition of their balance sheets--that is, the trade-off between lending and holding liquid assets--and hence the transmission of monetary policy (Bianchi and Bigio, 2017). In addition, we and others have noted that banks' preferences regarding the compositions of their liquid assets have influenced the Federal Open Market Committee's determination of "ample" reserves needed to effectively and efficiently implement monetary policy in the longer run; ultimately, these preferences affect the long-run size of the Federal Reserve's balance sheet. (2)

Because no historical time series of HQLA are available, we begin our analysis by constructing bank-level, quarterly estimates of HQLA from 1997 to the present. We focus on the three largest components of HQLA--banks' reserve balances held at the Federal Reserve and their holdings of both Treasury securities and certain mortgage-backed securities (MBS). We use our bank-level estimates to document how U.S. banks have managed the compositions of their HQLA pools over time. Not surprisingly given the Federal Reserve's large-scale asset purchases (LSAPs) that injected reserves into the banking system at the time, we find that during the run-up to becoming LCR compliant, banks in aggregate took on a significant quantity of excess reserves. However, after becoming compliant, many such banks adjusted their liquid asset holdings, reducing their stocks of reserve balances and raising their holdings of other HQLA components, presumably to achieve a more optimal configuration.

To explain this subsequent compositional adjustment, we use a risk-return framework that captures the relative return of the different HQLA components, the covariance of these returns, and the sensitivity of banks' preferences for these assets to a metric of their risk aversion. One can think of this model as capturing the decisions of a bank's treasury department. The bank treasurer oversees investments in various securities and cash instruments while providing for the bank's daily liquidity needs and meeting regulatory constraints such as the LCR. In particular, in managing the bank's liquid assets, the treasurer considers liquidity risk--the risk that cash is not immediately available when needed--and interest rate risk--in this case, the risk that the value of a liquid asset will change due to a change in interest rates. …

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