M-RCBG Associate Working Paper No. 140

The Effects of Liquidity Regulation on Bank Demand for Reserves and the Federal Reserve’s Balance Sheet Policy

Winner, 2020 Dunlop Thesis Prize

Laura Nicolae



Over the past two years, high bank demand for reserves has generated volatility in short-term interest rates and impaired the Federal Reserve's (Fed's) control of the fed funds rate. Policymakers have speculated that liquidity regulations that require banks to hold safe and liquid assets may explain banks' high reserve demand, but prior research has not quantified these effects. This paper examines the effect of the Liquidity Coverage Ratio (LCR) - the first standardized minimum liquidity requirement for large U.S. banks - on banks' reserve demand. I find that the LCR's announcement increased banks' reserve demand by 67-99%. This implies that to control interest rates, the Fed must maintain a reserve supply $219-325 billion larger than before the LCR. I also estimate that the reserve demand curve shifted out by $170 billion after the LCR's announcement, although this may not solely reflect the LCR. These results imply that the LCR partly explains the Fed's reduced control of interest rates but does not explain the majority of the increase in banks' reserve demand since the financial crisis.

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