The unprecedented growth in central banks’ balance sheets since the financial crisis has had a negative impact on the way in which financial markets function, according to a new report from the Bank for International Settlements.
Over the past decade the world’s major central banks have lent vast sums of cheap money as well as buying trillions of dollars in bonds and other assets in a bid to stimulate the global economy. Some are still expanding their balance sheets: the European Central Bank last month decided to restart its €2.6tn bond-buying programme, while the Bank of Japan has used bond-buying as a stimulus measure for decades.
Last month’s spike in short-term US borrowing costs was just the latest in a series of market shocks that have fuelled investors’ suspicions that this radical monetary policy is having an impact on how financial markets function.
The BIS, the central bank for central banks, said on Monday that, while the immediate impact had eased the severe market strains created by the 2008 financial crisis, there had been several negative side-effects. These included a scarcity of bonds available for investors to purchase, squeezed liquidity in some markets, higher levels of bank reserves and fewer market operators actively trading in some areas.
“Lower trading volumes and price volatility, compressed credit spreads and flatter term structures may reduce the attractiveness of investing and dealing in bond markets,” the BIS said in a report published on Monday. “Some players may leave the market altogether, resulting in a more concentrated and homogenous set of investors and fewer dealers.”
This “could result in market malfunctioning when large central bank balance sheets are eventually unwound”, the BIS warned. “For instance, it could make it more difficult for reserves to be redistributed effectively between market participants.”
Negative impacts have been more prevalent when central banks hold a larger share of outstanding assets, the BIS said; major central banks’ holdings of domestic sovereign bonds range from 20 per cent of outstanding paper at the US Fed to over 40 per cent in Japan.
But the BIS said these side-effects had so far only rarely affected financial conditions in such a way as to impede central banks’ monetary policymaking, though it added that the full consequences were unlikely to become clear until major central banks started to shrink their balance sheets.
Fears about the side-effects of the past decade of unprecedentedly loose monetary policy were highlighted last month by a sharp rise in borrowing costs in the US overnight money markets. The US Federal Reserve — which recently halted the scaling-back of its balance sheet — was forced to inject $140bn of liquidity to ease the squeeze.
As the Fed conducts a post mortem into the event, it is looking at how banking regulation, supervision and risk management policies affect its own balance sheet.
A significant increase in sales of US Treasuries over the past couple of years has meant that investors have not experienced a shortage of bonds to buy, and thus the Fed’s bond-buying programme “appeared to have little impact on Treasury market functioning”, the BIS said
But the growth in the quantity of financial assets held by the Fed resulted in an offsetting expansion in the liability side of the Fed’s balance sheet, as it lent out more cash reserves to banks.
Policymakers had expected that the handful of large Wall Street banks that hold about a quarter of US banks’ total reserves would lend them out overnight when rates rose high enough — but, during last month’s market strain, that did not happen.
The BIS noted that regulations demanding liquidity at large banks might discourage the banks from offering to lend out their reserves — a source of same-day liquidity — into overnight markets. This is similar to what the large banks themselves have said in the last month.
But the BIS also noted that since the financial crisis, risk management practices might have changed within the banks themselves.
Eric Rosengren, president of the Boston Fed, agreed, telling the FT on Saturday that differences in reserve holdings among the large banks showed that reluctance to lend reserves was likely to be a consequence of “tastes and preferences” specific to each bank.