ContextDelivered by the head of the Bank for International Settlements, the central banks' bank, whose mission is to support global monetary and financial stability and whose main challenge is a changing policy toolkit.
Why it mattersIt shows how the size of a central bank's balance sheet links to bank liquidity and financial stability, a design choice many central banks are now reconsidering.
- When banks hold fewer reserves, they lean harder on interbank lending and on selling securities to find cash.
- In stress, interbank markets can split apart, leaving some banks short of reserves at the end of the day.
- Reserve demand can swing unpredictably when banks that rarely trade become sources of sudden payment flows.
- Choose an operating framework that keeps a high level of excess reserves as a liquidity buffer for banks.
- Rely on reserves rather than other liquid assets to reduce banks' exposure to government debt.
- Study how tiering and other designs, as used in Japan and Sweden, affect market functioning before deciding.
Read the speech summary
1. The question and the scope
At the ECB's conference on money markets, Pablo Hernández de Cos asks how large the lasting footprint of a monetary authority's assets and liabilities should be once crises have passed. These portfolios swelled after the 2008 crisis and the pandemic, and have been shrinking in the euro area since 2022 and in many other economies. He sets aside emergency episodes and the lower-bound problem, concentrating on the reserves that commercial banks hold at the central bank. Two forces set their level: the operating framework, which fixes supply, and banks' own demand. Because financial systems, institutions and objectives differ, countries can reasonably draw different conclusions.
2. Operating frameworks
Frameworks differ by where supply meets the demand curve. In a corridor or scarce-reserves system, supply sits on the sloping part and banks forgo a positive return when they park reserves overnight, as in Brazil, India or Korea. Ample or abundant systems, such as the euro area's, push the market rate toward or below the deposit rate. Tiered designs pay a lower rate above a quota; Switzerland uses one to keep trading alive despite plentiful reserves. The ideal opportunity cost is debated: a textbook rule favours cheap, plentiful reserves, yet a large central bank footprint can distort allocation and crowd out private markets, while abundant liquidity can head off forced asset sales and scrambles for cash. Both effects coexist, so the net balance is hard to judge.
3. Monetary control and market functioning
Every framework can steer the policy stance, but with high reserves the operational target stays closer to the policy rate, since swings in currency demand or government deposits need no offsetting forecasts; scarce systems must intervene, though deviations are only a few basis points and do not seem to spread to other short rates. Plentiful reserves also let a central bank add liquidity without disturbing rate control. As reserves become abundant, trading incentives fade and interbank activity can wither; in Sweden around half of counterparties have taken part in no money market segment since 2020. Tiering sustains trading. Views differ on how much interbank turnover matters, since secured markets stay busy and supervision can supply discipline, and a recent ECB study finds unsecured lending carries higher regulatory costs than collateralised lending, though Japan's unsecured market recovered after tiering.
4. Financial stability
Abundant-reserve systems supply liquidity in advance, scarce ones provide it after stress appears, often at penalty rates against strict collateral. A large reserve cushion helps banks absorb shocks, lowers reliance on frozen interbank lending, forced sales of other liquid assets and emergency facilities, and trims banks' holdings of government bonds, weakening the sovereign-bank link. In stress, fragmented markets can leave some banks short at day's end. Yet the system may adapt to abundance in ways that raise fragility.
5. What drives reserve demand
Demand has risen over the past decade. Liquidity rules matter in different ways: intraday requirements or supervisory pressure behave like reserve requirements, whereas the standard coverage ratio can be met with other liquid assets, so it shows little link to reserve levels; reserves merely take a larger share as their opportunity cost falls. Frictions raise the insurance value of reserves: selling other liquid assets takes time, runs have become faster as the 2023 turmoil showed, borrowing from the central bank can carry stigma or lack operational readiness, and non-bank institutions may amplify swings in stress.
6. Endogenous effects and open questions
Demand may respond to the framework itself. When markets fragment, inactive banks act like autonomous factors whose payment flows move effective demand unexpectedly, and Swedish banks raised precautionary buffers as supply grew. High reserves may also encourage banks to take on more uninsured deposits and credit lines, leaving them more exposed if liquidity shrinks. Whether such effects can be undone as balance sheets fall is unresolved, though recent experience, including the euro area's, suggests a smooth reduction is achievable.