RDP 2024-08: Modelling Reserve Demand with Deposits and the Cost of Collateral 4. Sources of Reserve Demand

Before estimating banks' reserve demand curve, I first identify the sources of banks' reserve demand which can be split into three motives (Hauser 2023):

1. Transactional: to meet regular day-to-day payments.
2. Precautionary: to meet potential outflows from runnable liabilities in a stress.
3. Relative value: the idea that the demand for reserves will depend on their rate of return, relative to other assets.

Together, these motives suggest the shape of the demand curve is downward sloping and nonlinear and shed light on what could cause shifts in the demand curve, which I model in Section 6.

4.1 Transactional demand

Banks need to hold sufficient reserves to make payments (on behalf of customers) to other banks. Banks' transactional demand curve might be downward sloping because banks demand reserves for convenience (Lopez-Salido and Vissing-Jørgensen 2024). To meet its payments obligations, a bank can either run down its stock of reserves or borrow in repo or unsecured money markets. Holding reserves leads to transaction cost savings and better payment efficiency as banks can meet their obligations immediately by drawing down on their reserves instead of having to borrow.^[3] Banks' transactional demand curve is likely nonlinear as additional reserves become less and less useful for managing a given stock of short-term liabilities. In Australia, transaction cost savings from drawing down on reserves might be lower than in other jurisdictions, as banks have access to the RBA's automated intraday repo facility at zero financial cost.^[4] Australian banks can also satisfy some portion of their transactional demand using the RBA's open repo facility which provides counterparties with access to zero-interest open repo up to a limit set by the RBA.

If additional reserves are more useful for managing payments when short-term liabilities (proxied by deposits in this paper) are larger, then an increase in short-term liabilities results in a shift to the demand curve. Deposits have increased significantly since pre-COVID-19 due to a number of factors. One such factor is the RBA's bond purchases from non-banks. While the RBA bought bonds from commercial banks, some bonds were ultimately sourced from non-bank investors which commercial banks paid for with newly created deposits. Supplying reserves through the TFF also indirectly increased deposits as banks reduced bond issuance in lieu of cheaper TFF funding (Johnson 2022). When bank bonds matured, investors didn't buy new bonds and the cash they received at maturity was deposited at a bank instead. Other factors such as an increase in government spending and credit growth also contributed to the rise in deposits (Figure 3) (RBA 2020). To give a sense of magnitude, deposits increased around $900 billion between March 2020 and August 2024. Around $250 billion in deposits were created as a result of the RBA's bond purchases, given ‘much’ (say two-thirds) of these purchases were from the non-bank sector (RBA 2022b). Other factors are responsible for the rest of the increase in deposits such that the shift in banks' reserve demand curve explained by deposits is unlikely to be a result of the RBA's bond purchases alone. It also means that as the RBA's bond purchases mature, deposits (and reserve demand) are unlikely to decline significantly from their current level.

The usefulness of system deposits to capture growth in payments needs (i.e. transactional demand) likely varies over time. For example, credit growth creates deposits and is likely an indication of a growing economy or increased financialisation which increases payments needs. On the other hand, the central bank purchasing bonds from non-banks creates deposits but does not necessarily increase transactional demand if the proceeds from the bond sale solely represent an increase in household liquid wealth. During 2020, the stock of deposits rose while the daily average value of transactions settled fell (Figure 4). Since mid-2021, gross transaction volumes banks are required to manage have increased alongside deposit creation. The level of deposits also does not capture changes in the volatility of payment flows, which affects banks' transactional demand per dollar of deposits.

4.2 Precautionary demand

Banks might hold reserves as a precaution to protect against unexpectedly large outflows (Acharya and Rajan 2022). If facing an unexpectedly large withdrawal of funds, reserves are an immediate source of liquidity which can be drawn down. Other assets first need to be converted to reserves (‘monetised’) through outright sales or repo, which has the potential to increase the cost of meeting outflows by pushing down prices in outright markets or increasing repo rates.

Monetisation risk is often referenced in the context of liquidity coverage ratio (LCR) regulation. LCR banks are required to hold enough high-quality liquid assets (HQLA) to meet their anticipated net cash outflows (NCOs) if there was a liquidity stress event over the next 30 days. In Australia, reserves and bonds issued by federal, state and territory governments qualify as HQLA. While the LCR is agnostic on HQLA composition, banks may prefer to hold reserves to reduce monetisation risk as the size of outright and repo markets in which to liquidate HQLA securities in Australia is much smaller than banks' potential short-term liquidity needs (Figure 5). Operational considerations, such as settlement conventions (e.g. T + 2) and credit limits may also influence a bank's ability to monetise HQLA securities in size. The RBA's full-allotment OMO repo and other standing facilities could partially reduce precautionary demand for reserves because they allow counterparties to convert repo-eligible assets into reserves without limit.

In 2023, the Australia Prudential Regulation Authority (APRA) consulted on targeted changes to strengthen liquidity management practices and crisis preparedness. In the review, APRA asked banks to begin formally assessing the monetisation risk of HQLA securities in their internal liquidity stress tests (APRA 2024). Similarly, regulators in the United States require banks to recognise the monetisation risk of HQLA securities. Banks, as a result, hold precautionary reserve balances to meet internal liquidity stress tests (Andolfatto and Ihrig 2019; Board of Governors of the Federal Reserve System 2019; Nelson 2022).

Like transactional demand, the precautionary demand curve is likely to be downward sloping, nonlinear and shifted by the stock of short-term runnable liabilities. A downward-sloping precautionary demand curve implies that additional reserves reduce monetisation risk by reducing the size of bonds which need to be monetised in a stress (or a lower probability of needing to monetise bonds at all) (Bush et al 2019). Eventually, there should be a ‘saturation point’ where reserve balances converge on the size of the largest possible outflow during a liquidity stress event such that additional reserves will no longer reduce monetisation risk. An increase in short-term liabilities increases the possible size of a liquidity stress event such that the marginal reserve balance becomes more valuable in reducing monetisation risk; short-term liabilities shift the precautionary demand curve. One potential omission from this framework is the effect of a change in banks' preference for how many precautionary reserves to hold per dollar of deposits. This preference could be driven by the distinction between reserves and government bonds in the eyes of regulators or a change in the composition of deposits from, say, insured to uninsured. My results are robust to using total or uninsured deposits.

Precautionary demand for reserves might have grown in recent years owing to an increase in the share of Australian banks' funding from short-term liabilities. As described above, unconventional monetary policy, alongside other factors, created a large amount of deposits – increasing banks' share of funding from short-term sources. More recently, the unwinding of unconventional policy measures has been accompanied by a modest fall in Australian banks' share of funding which is either overnight or at-call (Figure 6). The fall in claims on bank liquidity is unlike the US experience, where short-term claims on bank liquidity have not fallen during quantitative tightening (Acharya et al 2023). LCR banks' NCOs which they hold HQLA against are calculated by weighting each runnable liability proportional to the amount of funding which is expected to run in a 30-day liquidity stress event (known as a run-off rate). Weighting banks' overnight/at-call funding by their run-off rates shows that banks' anticipated overnight outflows in a stress have declined recently but remain elevated compared to pre-pandemic – potentially increasing banks' precautionary demand for reserves.

4.3 Relative value demand

Relative value demand represents reserves held to optimise banks' liquid asset portfolios (Borio, Disyatat and Schrimpf 2024). The LCR is agnostic on banks' HQLA portfolio composition, so banks should attempt to maximise profits by considering the risk-return trade-off between assets in the investable universe – reserves and government bonds. According to liaison, Australian banks consider the cost of holding reserves versus government bonds, where the return on these bonds is converted to a floating rate through swaps.^[5]

If an LCR bank holds reserves, they receive a return equal to the ES rate. The five largest LCR banks receive an additional benefit as a result of the ‘major bank levy’ – a 6 basis point tax applied to select liabilities minus reserve holdings (Hawkins and Sanyal 2017). Banks subject to the bank levy pay 6 basis points less tax when holding reserve balances such that their opportunity cost of holding reserves is the ES rate plus 6 basis points (Equation (1)).

To compare the return on reserves with government bonds, LCR banks convert the bond's fixed rate of interest into an overnight, floating rate by first entering into an asset swap where they pay the bond's fixed rate of interest and receive the 3-month bank bill swap rate (BBSW) plus a spread. Then, LCR banks contract a basis swap to convert BBSW into the cash rate plus a spread. The return on the government bond comparable to reserves is equal to the cash rate plus the asset and basis swap spreads net of any capital costs (Equation (2)). Capital costs vary with the maturity of the government bond. If an LCR bank wants to close its position it would have to execute an asset swap in the opposite direction and take losses proportional with how far asset swap spreads have moved since the initial execution date. These losses are likely to be larger the longer the maturity of the swap contract.

From Equations (1) and (2), relative value demand is likely to be downward sloping as the spread between the cash rate and ES rate affects the trade-off between reserves and government bonds – as the cash rate declines relative to the ES rate it becomes more profitable for banks to hold reserves.^[6] Relative value demand is likely shifted by changes in market prices which affect the trade-off between reserves and other HQLA (asset and basis swap spreads) (Borio 2023).

Prior to the pandemic, Australian Government Securities (AGS) were more profitable to hold than reserves (Figure 7).^[7] During the pandemic, a decrease in the cash rate spread to the ES rate and a decrease in swap spreads meant holding reserves became a more attractive option to LCR banks. Since late 2022, swap spreads and the cash rate (relative to the ES rate) have risen – reducing the profitability of LCR banks' holding reserves.

Footnotes

There is some evidence that additional reserves led to faster settlement of payments in the United States (Bech, Martin and McAndrews 2012). Payment efficiency has also increased in Australia, albeit to a lesser extent than the United States, since operating with a higher level of reserves (Kopec and Rao 2022). [3]

There may still be some cost associated with encumbering collateral intraday or an operational cost related to using the facility. [4]

Some banks consider the cost of hedging using futures, though this is less common. [5]

I use the repo rate, not the cash rate, to estimate demand for reserves. However, assuming negligible credit and liquidity risk difference between secured and unsecured rates, the spread between the repo and cash rate represents the value of collateral which I control for in my estimation. Thus, banks' reserve demand with respect to repo financing will also slope downward. [6]

I exclude showing hedged returns on state and territory government bonds for simplicity. [7]