The financial system has been awash with liquidity for a decade. As central banks begin to tighten monetary policy we will start to see liquidity being withdrawn alongside rising interest rates, with implications for how banks and other financial institutions manage their liquidity.
The Bank of England's new discussion paper on the future of its balance sheet and framework for controlling interest rates considers the implications of these changes.
As the Bank notes, firms now hold substantially larger liquid asset buffers than they did prior to the financial crisis, reflecting both the introduction of new prudential liquidity regulations in the years following the financial crisis, as well as firms’ own desire to self-insure for liquidity risks. Quantitative easing has to a large extent masked this increased demand; as liquidity is withdrawn it will become more important for the Bank to understand what quantity of central bank reserve balances banks will likely want to hold.
This is an active area of policy discussion, not just in UK. Back in May, US Vice Chairman for Supervision Randal K. Quarles raised similar issues in a speech examining how post-crisis financial regulation might influence the size and composition of the Federal Reserve's balance sheet.
Perhaps because of the abundance of liquidity, liquidity regulations have not occupied bankers' minds in the recent past in the same way that capital regulations have. This will change. Alongside the dynamics that the Bank highlights in its discussion paper, other factors such as expanding direct access to central bank reserves and open banking will drive changes to the price and availability of liquidity. Banks will need to factor these changes into their business strategy and risk management.
Retail deposits have grown quite a bit since the crisis, especially in light of the prolonged period of broad-based low interest rates and accommodative monetary policy, limiting the need for banks to compete for this most stable form of deposits. However, the combination of rising interest rates and the Fed's shrinking balance sheet, together with banks' ongoing need to meet the LCR, may alter these competitive dynamics