RDP 2024-08: Modelling Reserve Demand with Deposits and the Cost of Collateral 2. Background

Prior to the COVID-19 pandemic, the RBA supplied just enough reserves (around $3 billion) for banks to settle their interbank payments by the end of the day, known as a ‘scarce reserves’ system. Under scarce reserves, the RBA managed the supply of reserves to closely match demand such that the cash rate traded at target. While the cash rate traded at target, the overnight general collateral (GC) repo rate traded 10 to 20 basis points above cash rate. The difference in overnight rates represented a lack of arbitrage due to balance sheet limitations and because banks were less willing to lend in the repo market in the morning, wary that they may not be able to borrow back these funds in the cash market at the end of the trading day (Cheung and Printant 2019; Bristow and Tang 2024). The cash rate was also prevented from rising alongside repo rates due to a convention by cash market participants to almost always trade at the cash rate target (Kent 2024).

During the pandemic, the RBA ceased actively managing the supply of reserves when it began fulfilling all bids for liquidity at its OMO, purchased a large number of bonds and initiated the Term Funding Facility (TFF) (Debelle 2021). In doing so, the supply of reserves increased such that the cash and overnight GC repo rates converged on the interest paid on reserves – known as the ‘ES (exchange settlement) rate’ (Figure 1).

Since 2023, reserves have declined to around $200 billion from their peak of $450 billion as the RBA's bond purchases have begun to unwind and the TFF was repaid in full. While reserves remain at a high level relative to pre-pandemic, the decline in reserves has coincided with an increase in the cash and overnight repo rates (relative to the ES rate). The decline in reserves has revealed a time-varying relationship between the level of reserves and the spread between the overnight repo rate and the ES rate, akin to a shift in banks' reserve demand (Figure 2).