In the wake of the 2008 financial crisis, US and European regulators introduced prudential liquidity requirements. The goal here was twofold: to strengthen banks’ own liquidity risk management and to reduce the likelihood of a central bank emergency intervention being required during a shock. These rules require banks to hold sufficient high-quality liquid assets – such as central bank reserves or sovereign bonds – in order to cover any net cash outflows that could theoretically arise in a stress scenario. While these standards have improved banks’ liquidity positions, they have also had two unintended consequences.
Firstly, central banks are now forced to act as lenders of first resort in normal times, i.e., to supply the banking system with liquidity on an ongoing basis. The Fed’s inability to reduce its balance sheet significantly post-quantitative easing underscores this shift. The massive bond purchases following the 2008 crisis and the COVID-19 shock in 2020 were designed to ease financial strains. However, by injecting a large amount of central bank money into the financial system, these episodes of QE also helped banks to meet the new liquidity requirements. As the rules created a strong, persistent demand for central bank money, they are now preventing the Fed from unwinding its balance sheet.
The second side effect is that the Fed can no longer fulfil its role as lender-of-last-resort fully during periods of stress. Liquidity rules have heightened the stigma attached to the discount window, discouraging banks from using it or even preparing to do so. In recent shocks, discount-window borrowing has remained modest compared with the use of ad-hoc emergency facilities or loans from the Federal Home Loan Banks. The 2023 banking run even showed that some banks were unable to obtain an emergency loan because they had not pre-positioned, or had insufficiently pre-positioned, collateral with the Fed. This reluctance to make use of the discount window is still high, as, at the end of 2023, only 57?% of banks had access to the window and just 31?% had pre-positioned assets
In order to address this, the Treasury Secretary has recently suggested that the regulatory framework recognise banks’ capacities to draw-down at the discount window. A portion of the pre-positioned assets would be counted among the eligible liquid assets for liquidity-ratio calculations. The aim of this is to destigmatise the emergency window and thereby restore the Fed’s ability to intervene during stress. If this easing successfully lowers the desired minimum reserve level, it could free up space on banks’ balance sheets for less-liquid assets, such as loans, which currently account for two-thirds of the collateral pledged at the discount window. It might even allow the Fed to reconsider balance sheet reduction.
However, another lesson from the 2023 banking run could potentially be overlooked: the need to broaden liquidity rules’ scope, which is currently very limited. While all European banks are subject to such rules, in the United States, only about thirty large banking groups are.
