RDP 2024-08: Modelling Reserve Demand with Deposits and the Cost of Collateral 1. Introduction

Central bankers in Australia and overseas are actively considering how best to design their monetary policy implementation system – the method by which they control short-term interest rates. Deposits held by commercial banks at the central bank – known as reserves – play an essential role in how the Reserve Bank of Australia (RBA) achieves interest rate control. Commercial banks are required to use reserves to settle payments with one another and the RBA. When a bank has insufficient reserves to settle their payments, they can borrow for a short time from other banks. The volume-weighted interest rate on these transactions is the cash rate – the RBA's interest rate target.

In Australia, the supply of reserves has declined as unconventional policies enacted during COVID-19 unwind, prompting discussion over the appropriate steady-state supply of reserves. To this end, the RBA recently announced it will operate an ‘ample reserves’ system where it supplies as many reserves as banks demand through open market operations (OMO) repo. The European Central Bank, Bank of England and Sweden's Riksbank have announced they will operate similar systems (Schnabel 2024; Ramsden 2018; Sveriges Riksbank 2019). This system is often referred to as a ‘demand-driven’ system because the value of reserves supplied by the central bank is determined by the banking system's demand, subject to the price set by the central bank.

I estimate Australian banks' reserve demand curve and its drivers. This is important for two reasons. First, banks' reserve demand will be an important determinant of the size of the RBA's balance sheet and its presence in financial markets. Second, the supply of reserves has been above the level banks would willingly hold at the price offered by the RBA since unconventional monetary policy measures were enacted during the COVID-19 pandemic. As unconventional policy unwinds, the supply of reserves will eventually fall to a point close to banks' underlying demand. At this point, banks will begin to demand additional reserves through the RBA's OMO, marking the transition from abundant reserves to its chosen system of ample reserves. Understanding banks' reserve demand aids in anticipating the timing of the transition.

There are two novel features of my work. First, I study reserve demand in the Australian context for the first time. Second, I model the time-varying cost of collateral and estimate its effect on the demand for reserves.

My work is closest to Lopez-Salido and Vissing-Jørgensen (2024), as I use their convenience yield framework to model the demand for reserves. Their focus is, however, on the US context, and in modelling reserve demand with respect to the overnight unsecured rate. I focus on the Australian context and overnight repo rate due to institutional features in Australian short-term money markets.

Given the RBA's current OMO price, my results suggest banks will demand somewhere between $100 billion and $200 billion of excess reserves (reserves held over and above minimum requirements imposed by the RBA).^[1] Taking these estimates at face value, the RBA will be required to inject significantly more reserves to implement monetary policy than prior to the COVID-19 pandemic, when excess reserves averaged around $3 billion. Partly, what appears likely to be an increase in Australian banks' reserve demand reflects a decrease in the cost of borrowing under repo from OMO – a movement along banks' reserve demand curve. I find an increase in banking system deposits can explain a large part of the increase in reserve demand – a shift to the right in Australian banks' reserve demand curve. A shift in banks' reserve demand is not unique to Australia: existing research has documented the phenomenon in many jurisdictions including the euro area, the United Kingdom and the United States (Vissing-Jørgensen 2023; Meinecke 2023; Lopez-Salido and Vissing-Jørgensen 2024). The explanatory power of deposits suggests banks are willing to pay for the convenience of holding additional reserves to manage payments between depositors or that banks hold a precautionary reserve buffer against deposits in case of a liquidity stress.

Illustrating the high degree of uncertainty in estimating reserve demand, the supply of reserves at 30 October 2024 is around the upper range of my estimates while projections for the supply of reserves do not reach the lower range of my estimates until late 2026.^[2]

The paper proceeds as follows. Section 2 provides background to establish how reserve demand might have changed since the COVID-19 pandemic. Section 3 outlines literature which addresses the challenges in estimating reserve demand. Section 4 presents a conceptual framework for the motivations behind banks' reserve demand which informs the data and modelling choices in Sections 5 and 6. Section 7 presents results from the modelling exercise, the implications of which are discussed in Section 8.

Footnotes

Unless stated otherwise, I use ‘reserves’ to refer to excess reserves. For more details, see Section 5.1. [1]

Considering the maturity profile of RBA bond holdings and other factors that drain reserves, such as growth in banknote demand. See Section 8 for more detail. [2]