A Bank for International Settlements working paper finds that post-crisis liquidity regulation, frictions in converting government bonds into reserves and fragmented interbank markets generally reshape central bank reserve demand rather than uniformly shift it outward. The analysis concludes that none of these factors prevents central banks from returning to pre-Great Financial Crisis operating frameworks with scarce reserves. The Liquidity Coverage Ratio does not raise reserve demand when banks can satisfy it with other high-quality liquid assets and may lower demand in parts of the curve. Monetization frictions make demand more elastic and raise the satiation level, requiring more reserves for central banks operating near that point. Interbank market fragmentation has a different effect by weakening the link between aggregate reserve supply and market rates, increasing rate uncertainty and causing effective reserve demand to shift outward after negative supply shocks, particularly when initial reserve supply is high. The paper suggests that central banks seeking smaller balance sheets could reduce monetization frictions by improving repo and government bond market functioning and limit fragmentation by encouraging banks to remain active in money markets. Any transition to a scarce-reserve framework would need to give banks time to rebuild trading capacity.

Original source