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May 4, 2018

Liquidity Regulation and the Size of the Fed’s Balance Sheet

Remarks by
Randal K. Quarles
Vice Chairman for Supervision
Board of Governors of the Federal Reserve System
at
“Currencies, Capital, and Central Bank Balances: A Policy Conference”
a Hoover Institution Monetary Policy Conference
Stanford University
Stanford, California

May 4, 2018
Revised version: August 3, 2018

Vice Chairman for Supervision Quarles updated his remarks to reflect their publication in
Currencies, Capital, and Central Bank Balances. Hoover Institution Press
(Forthcoming).

Thank you very much to the Hoover Institution for hosting this important
conference and to John Taylor and John Cochrane for inviting me to participate. 1 In my
capacity as both the Vice Chairman for Supervision at the Board of Governors and a
member of the Federal Open Market Committee (FOMC), part of my job is to consider
the intersection of financial regulatory and monetary policy issues, the subject of my
discussion today. This topic is both complex and dynamic, especially as both regulation
and the implementation of monetary policy continue to evolve.
One important issue for us at the Fed, and the one that I will spend some time
reflecting on today, is how post-crisis financial regulation, through its incentives for bank
behavior, may influence the size and composition of the Federal Reserve’s balance sheet
in the long run. Obviously, the whole excessively kaleidoscopic body of financial
regulation is admittedly difficult to address in the time we have today, so I will focus on a
particular component -- the Liquidity Coverage Ratio (LCR--and its link to banks’
demand for U.S. central bank reserve balances. Besides illuminating this particular issue,
I hope my discussion will help illustrate the complexities associated with the
interconnection of regulatory and monetary policy issues in general. Also, let me
emphasize at the outset that I will be touching on some issues that the Board and the
FOMC are in the process of observing and evaluating and, in some cases, on which we
may be far from reaching any final decisions. As such, my thoughts on these issues are
my own and are likely to evolve, benefiting from further discussion and our continued
monitoring of bank behavior and financial markets over time.

1

The views I express here are my own and not necessarily those of the Federal Reserve Board or the
Federal Open Market Committee.

-2Monetary Policy and the Efficiency of the Financial System
Before I delve into the more specific complicated subject of how one type of bank
regulation affects the Fed’s balance sheet, let me say a few words about financial
regulation more generally.
As I have said previously, I view promoting the safety, soundness, and efficiency
of the financial system as one of the most important roles of the Board. Improving
efficiency of the financial system is not an isolated goal. The task is to enhance
efficiency while maintaining the system’s resiliency. Take, for example, the Board’s two
most recent and material proposals, the stress capital buffer and the enhanced
supplementary leverage ratio (eSLR). The proposal to modify the eSLR, in particular,
initially raised questions in the minds of some as to whether it would reduce the ability of
the banking system to weather shocks. A closer look at the proposal shows that the
opposite is true. The proposed change simply restores the original intent of leverage
requirements as a backstop measure to risk-based capital requirements. As we have seen,
a leverage requirement that is too high favors high-risk activities and disincentivizes lowrisk activities.
We had initially calibrated the leverage ratio at a level that caused it to be the
binding constraint for a number of our largest banks. As a result, those banks had an
incentive to add risk rather than reduce risk in their portfolios because the capital cost of
each additional asset was the same whether it was risky or safe, and the riskier assets
would produce the higher return. The proposed recalibration eliminates this incentive by
returning this leverage ratio to a level that is a backstop rather than the driver of decisions
at the margin. Yet, because of the complex way our capital regulations work together--

-3with risk-based constraints and stress tests regulating capital at both the operating and
holding company levels--this improvement in incentives is obtained with virtually no
change in the overall capital requirements of the affected firms. Federal Reserve staff
estimate the proposal would potentially reduce capital requirements across the eight large
banks subject to the proposal by $400 million, or 0.04 percent of the $955 billion in
capital these banks held as of September 2017. 2 So this recalibration is a win-win: a
material realignment of incentives to reduce a regulatory encouragement to take on risk at
a time when we want to encourage prudent behavior without any material capital
reduction or cost to the system’s resiliency. Taken together, I believe these new rules
will maintain the resiliency of the financial system and make our regulation simpler and
more risk sensitive.
Liquidity Regulations
Let me now back up to the time just before the financial crisis and briefly describe
the genesis of liquidity regulations for banks. Banking organizations play a vital role in
the economy in serving the financial needs of U.S. households and businesses. They
perform this function in part through the mechanism of maturity transformation--that is,
taking in short-term deposits, thereby making a form of short-term, liquid investments
available to households and businesses, while providing longer-term credit to these same
entities. This role, however, makes banking firms vulnerable to the potential for rapid,
broad-based outflows of their funding (a so-called run), and these institutions must

2

Required capital at the bank subsidiaries of these firms would be reduced by larger amounts--and would
only allow the firm to move that capital to different subsidiaries within the firm—but, more importantly,
the overall capital regime prevents this capital from being distributed out of the banking organization as a
whole except in this de minimis amount. Thus, the overall organization retains the same capital levels
without the structure of capital regulation creating an incentive to add risk to the system.

-4therefore balance the extent of their profitable maturity transformation against the
associated liquidity risks. 3 Leading up to the 2007-09 financial crisis, some large firms
were overly reliant on certain types of short-term funding and overly confident in their
ability to replenish their funding when it came due. Thus, during the crisis, some large
banks did not have sufficient liquidity, and liquidity risk management at a broader set of
institutions proved inadequate at anticipating and compensating for potential outflows,
especially when those outflows occurred rapidly. 4
In the wake of the crisis, central banks and regulators around the world
implemented a combination of regulatory reforms and stronger supervision to promote
increased resilience in the financial sector. With regard to liquidity, the prudential
regulations and supervisory programs of the U.S. banking agencies have resulted in
significant increases in the liquidity positions and changes in the risk management of our
largest institutions. And, working closely with other jurisdictions, we have also
implemented global liquidity standards for the first time. These standards seek to limit
the effect of short-term outflows and extended overall funding mismatches, thus
improving banks’ liquidity resilience.
One particular liquidity requirement for large banking organizations is the
Liquidity Coverage Ratio, or LCR, which the U.S. federal banking agencies adopted in
2014. 5 The LCR rule requires covered firms to hold sufficient high-quality liquid assets

3

While deposit insurance helps mitigate the incentive for many depositors to run, it cannot fully eliminate
this risk. For a discussion of this vulnerability, see Douglas W. Diamond and Philip H. Dybvig (1983),
“Bank Runs, Deposit Insurance, and Liquidity,” Journal of Political Economy, vol. 91 (June), pp. 401-19.
4
See Senior Supervisors Group (2009), Risk Management Lessons from the Global Banking Crisis of 2008
(New York: Federal Reserve Bank of New York, October),
https://www.newyorkfed.org/medialibrary/media/newsevents/news/banking/2009/SSG_report.pdf.
5
For a full description of the U.S. LCR, including which banks are covered, see Regulation WW--Liquidity
Risk Management Standards, 12 C.F.R. pt. 249 (2017), https://www.gpo.gov/fdsys/granule/CFR-2017title12-vol4/CFR-2017-title12-vol4-part249.

-5(HQLA)--in terms of both quantity and quality--to cover potential outflows over a 30-day
period of liquidity stress. The LCR rule allows firms to meet this requirement with a
range of cash and securities and does not apply a haircut to reserve balances or Treasury
securities based on the estimated liquidity value of those instruments in times of stress.
Further, firms are required to demonstrate that they can monetize HQLA in a stress event
without adversely affecting the firm’s reputation or franchise.
The rules have resulted in some changes in the behavior of large banks and in
market dynamics. Large banks have adjusted their funding profiles by shifting to more
stable funding sources. Indeed, taken together, the covered banks have reduced their
reliance on short-term wholesale funding from about 50 percent of total assets in the
years before the financial crisis to about 30 percent in recent years, and they have also
reduced their reliance on contingent funding sources. Meanwhile, covered banks have
also adjusted their asset profiles, materially increasing their holdings of cash and other
highly liquid assets. In fact, these banks’ holdings of HQLA have increased significantly,
from fairly low levels at some firms in the lead-up to the crisis to an average of about 15
to 20 percent of total assets today. 6 A sizable portion of these assets currently consists of
U.S. central bank reserve balances, in part because reserve balances, unlike other types of
highly liquid assets, do not need to be monetized, but also, importantly, because of the
conduct of the Fed’s monetary policy, a topic to which I will next turn.

6

See Jane Ihrig, Edward Kim, Ashish Kumbhat, Cindy M. Vojtech, and Gretchen C. Weinbach (2017),
“How Have Banks Been Managing the Composition of High-Quality Liquid Assets?” Finance and
Economics Discussion Series 2017-092 (Washington: Board of Governors of the Federal Reserve System,
August; revised February 2018), https://www.federalreserve.gov/econres/feds/files/2017092r1pap.pdf.

-6How Does the LCR Interact with the Size of the Fed’s Balance Sheet?
With this backdrop, a relevant question for monetary policymakers is, what
quantity of central bank reserve balances will banks likely want to hold, and, hence, how
might the LCR affect banks’ reserve demand and thereby the longer-run size of the Fed’s
balance sheet? Let me emphasize that policymakers have long been aware of the
potential influence that regulations may have on reserve demand and thus the longer-run
size of the Fed’s balance sheet. And, of course, regulatory influences on banks’ behavior,
my focus today, is just one of many factors that could affect policymakers’ decisions
regarding the appropriate long-run size of the Fed’s balance sheet. 7 In particular, in
augmenting its Policy Normalization Principles and Plans, the FOMC stated in June 2017
that it “currently anticipates reducing the quantity of reserve balances, over time, to a
level appreciably below that seen in recent years but larger than before the financial
crisis” and went on to note that “the level will reflect the banking system’s demand for
reserve balances and the Committee’s decisions about how to implement monetary policy
most efficiently and effectively in the future.” 8
With that said, it is useful to begin by examining banks’ current reserve holdings.
Figure 1 plots the aggregate level of reserve balances in the U.S. banking system, starting
well before the financial crisis. As you can see, the current level of reserves--at around

7

For example, a separate factor that is relevant for policymakers in this regard is the FOMC’s choice of
long-run framework for monetary policy implementation. For policymakers’ discussions of this factor, see
Board of Governors of the Federal Reserve System (2016), “Minutes of the Federal Open Market
Committee, July 26-27, 2016,” press release, August 17,
https://www.federalreserve.gov/newsevents/pressreleases/monetary20160817a.htm; and Board of
Governors of the Federal Reserve System (2016), “Minutes of the Federal Open Market Committee,
November 1-2, 2016,” press release, November 23,
https://www.federalreserve.gov/newsevents/pressreleases/monetary20161123a.htm.
8
See Board of Governors of the Federal Reserve System (2017), “FOMC Issues Addendum to the Policy
Normalization Principles and Plans,” press release, June 14, paragraph 6,
https://www.federalreserve.gov/newsevents/pressreleases/monetary20170614c.htm.

-7$2 trillion--is many orders of magnitude higher than the level that prevailed before the
financial crisis, a result of the Fed’s large-scale asset purchase programs or “quantitative
easing.” The vertical lines in the figure show key dates in the implementation of the
LCR, including the initial Basel III international introduction of the regulation followed
by its two-step introduction in the United States. A key takeaway from this figure is that
the Fed was in the process of adding substantial quantities of reserve balances to the
banking system while the LCR was being implemented--and these two changes largely
happened simultaneously. As a result, banks, in aggregate, are currently using reserve
balances to meet a significant portion of their LCR requirements. In addition, because
these changes happened together, it is reasonable to conclude that the current
environment is likely not very informative about banks’ underlying demand for reserve
balances.
But now the situation is changing, albeit very slowly. Last October, the Fed
began to gradually and predictably reduce the size of its balance sheet. 9 The Fed is doing
so by reinvesting the principal payments it receives on its securities holdings only to the
extent that they exceed gradually increasing caps--that is, the Fed is allowing securities to
roll off its portfolio each month up to a specific maximum amount. This policy is also
reducing reserve balances. So far, after the first seven months of the program, the Fed
has shed about $120 billion of its securities holdings, which is a fairly modest amount
when compared with the remaining size of its balance sheet. Consequently, the level of
reserves in the banking system is still quite abundant.

9

The FOMC announced this change to its balance sheet policy in its September 2017 postmeeting
statement; see Board of Governors of the Federal Reserve System (2017), “Federal Reserve Issues FOMC
Statement,” press release, September 20,
https://www.federalreserve.gov/newsevents/pressreleases/monetary20170920a.htm.

-8So, how many more reserve balances can be drained, and how small will the
Fed’s balance sheet get? Let me emphasize that this question is highly speculative--we
have not decided ex ante the desired long-run size of the Fed’s balance sheet, nor, as I
noted earlier, do we have a definitive handle on banks’ long-run demand for reserve
balances. Indeed, the FOMC has said that it “expects to learn more about the underlying
demand for reserves during the process of balance sheet normalization.” 10 Nonetheless,
let me spend a little time reflecting on this challenging question.
How banks respond to the Fed’s reduction in reserve balances could, in theory,
take a few different forms. One could envision that as the Fed reduces its securities
holdings, a large share of which consists of Treasury securities, banks would easily
replace any reduction in reserve balances with Treasury holdings, thereby keeping their
LCRs roughly unchanged. According to this line of thought, because central bank
reserve balances and Treasury securities are treated identically by the LCR, banks should
be largely indifferent to holding either asset to meet the regulation. In that case, the
reduction in reserves and corresponding increase in Treasury holdings might occur with
relatively little adjustment in their relative rates of return.
Alternatively, one could argue that banks may have particular preferences about
the composition of their liquid assets. And since banks are profit-maximizing entities,
they will likely compare rates of return across various HQLA-eligible assets in
determining how many reserves to hold. If relative asset returns are a key driver of
reserve demand, then interest rates across various types of HQLA will adjust on an

10

See Board of Governors, “FOMC Issues Addendum,” paragraph 6, in note 7.

-9ongoing basis until banks are satisfied holding the aggregate quantity of reserves that is
available.
Recent research by the Board staff shows that banks currently display a
significant degree of heterogeneity in their approaches to meeting their LCR
requirements, including in their chosen volumes of reserve balances. 11 Figure 2 shows a
subset of this research to illustrate this point. The top and bottom panels represent
estimates of how two large banks have been meeting their HQLA requirements over time.
In each panel, the blue portions of the bars denote the share of HQLA met by reserve
balances, while the red, yellow, and brown slices of the bars represent the share met by
Treasury securities, agency mortgage-backed securities, and other HQLA-eligible assets,
respectively. Despite holding roughly similarly amounts of HQLA, the two banks exhibit
very different HQLA compositions, with the bank depicted in the top panel consistently
holding a much larger share of HQLA in the form of reserve balances than the bank
shown in the bottom panel. This finding suggests that there likely is no single
“representative bank” behavioral model that can capture all we might want to know about
banks’ demand for central bank reserve balances.
Some of the differences we see in bank behavior likely relate to banks’ individual
liquidity needs and preferences. Indeed, banks manage their balance sheets in part by
taking into account their internal liquidity targets, which are determined by the
interaction between the specific needs of their various business lines and bank
management’s preferences. In any case, this picture illustrates the complexities that are

11

See Ihrig and others, “Managing the Composition of High-Quality Liquid Assets,” in note 5.

- 10 inherent in understanding banks’ underlying demand for reserve balances, a topic for
which more research would be quite valuable to policymakers.
So, what does this finding say about the longer-run level of reserve balances
demanded by banks? The answer is that there is a large degree of uncertainty. In fact,
the Federal Reserve Bank of New York surveyed primary dealers and market participants
last December to solicit their views about the level of reserves they expect to prevail in
2025. 12 A few features of the survey responses stand out. All respondents thought that
the longer-run level of reserve balances would be substantially lower than the current
level of more than $2 trillion. In addition, there appeared to be a widely held view that
the longer-run level of reserves will be significantly above the level that prevailed before
the financial crisis. But even so, the respondents did not agree about what that longer-run
level will be, with about half expecting a level ranging between $400 billion and
$750 billion.
It is also important to point out that the Fed’s balance sheet will remain larger
than it was before the crisis even after abstracting from the issue of banks’ longer-run
demand for reserve balances. The reason is that the ultimate size of the Fed’s balance
sheet also depends on developments across a broader set of Fed liabilities. One such
liability is the outstanding amount of Federal Reserve notes in circulation--that is, paper
money--which has doubled over the past decade to a volume of more than $1.6 trillion,
growing at a rate that generally reflects the pace of expansion of economic activity in
nominal terms. When I left my position in the Bush Treasury in 2006, by contrast, the

12

The December 2017 Survey of Primary Dealers is available on the Federal Reserve Bank of New York’s
website at https://www.newyorkfed.org/medialibrary/media/markets/survey/2017/dec-2017-spd-results.pdf.
The December 2017 Survey of Market Participants is available at
https://www.newyorkfed.org/medialibrary/media/markets/survey/2017/dec-2017-smp-results.pdf.

- 11 total amount of paper currency outstanding was not quite $800 billion. Other nonreserve
liabilities have also grown since the crisis, including the Treasury Department’s account
at the Fed, known as the Treasury’s General Account. Recent growth in such items
means that the longer-run size of the Fed’s balance sheet will be noticeably larger than
before the crisis regardless of the volume of reserve balances that might ultimately
prevail.
Putting the various pieces together, figure 3 illustrates how the overall size of the
Fed’s balance sheet may evolve. Given the uncertainties I have described, I have chosen
to show three different scenarios, drawn from the most recent annual report released by
the Federal Reserve Bank of New York, which was published last month. 13 These
scenarios highlight the degree to which the longer-run size of the Fed’s domestic
securities portfolio--also known as the System Open Market Account, or SOMA, which
accounts for the vast majority of the Fed’s assets--will be affected by choices about the
future level of reserve balances and the evolution of nonreserve liabilities. The
assumptions underlying the scenarios are based on the distribution of responses from the
surveys I described earlier, as those surveys also asked respondents to forecast the likely
longer-run levels of several liabilities on the Fed’s balance sheet other than reserves.
The “median” scenario, represented by the red (middle) line in the figure, is based on the
50th percentile of survey responses, while the “larger” and the “smaller” scenarios,
denoted by the gold dashed (top) and blue dotted (bottom) lines, are based on the
75th and 25th percentiles, respectively.

13

See Federal Reserve Bank of New York (2018), Open Market Operations during 2017 (New York:
FRBNY, April), available at https://www.newyorkfed.org/markets/annual_reports.html. Among other
things, the report reviews the conduct of open market operations and other developments that influenced
the System Open Market Account of the Federal Reserve in 2017.

- 12 The figure illustrates that the Fed’s securities holdings are projected to decline
about $400 billion this year and another $460 billion next year as Treasury and agency
securities continue to roll off gradually from the Fed’s portfolio. The kink in each curve
captures what the FOMC has referred to as the point of “normalization” of the size of the
Fed’s balance sheet--that is, the point at which the balance sheet will begin to expand
again to support the underlying growth in liabilities items such as Federal Reserve notes
in circulation. All else being equal, greater longer-run demand for currency, reserve
balances, or other liabilities implies an earlier timing of balance sheet normalization and a
higher longer-run size of the balance sheet, as illustrated by the top line. And the
converse--smaller demand for these liabilities and a later timing of normalization,
illustrated by the bottom line--is also possible. In the three scenarios shown, the size of
the Fed’s securities portfolio normalizes sometime between 2020 and 2022. That is quite
a range of time, so as the balance sheet normalization program continues, the Fed will be
closely monitoring developments for clues about banks’ underlying demand for reserves.
What will the Fed be monitoring as reserves are drained and the balance sheet
shrinks? I would first like to emphasize that the Fed regularly monitors financial markets
for a number of reasons, so I do not mean to imply that we will be doing anything that is
very much different for our normal practice. As reserves continue to be drained, we will
want to gauge how banks are managing their balance sheets in continuing to meet their
LCRs, watching in particular how the distribution of reserve balances across the banking
system evolves as well as monitoring any large-scale changes in banks’ holdings of other
HQLA-eligible assets, including Treasury securities and agency mortgage-backed
securities.

- 13 And on the liabilities side of banks’ books, we will be keeping our eye on both the
volume and the composition of deposits, as there are reasons why banks may take steps,
over time, to hold onto certain types of deposits more than others. In particular, retail
deposits may be especially desired by banks going forward because they receive the most
favorable treatment under the LCR and also tend to be relatively low cost.
Retail deposits have grown quite a bit since the crisis, especially in light of the
prolonged period of broad-based low interest rates and accommodative monetary policy,
limiting the need for banks to compete for this most stable form of deposits. However,
the combination of rising interest rates and the Fed’s shrinking balance sheet, together
with banks’ ongoing need to meet the LCR, may alter these competitive dynamics.
Of course, importantly, deposits will not necessarily decline one-for-one with
reserve balances as the Fed’s balance sheet shrinks. The overall effects of the decline in
the Fed’s balance sheet will depend both on who ultimately ends up holding the securities
in place of the Fed and on the full range of portfolio adjustments that other economic
agents ultimately make as a result. 14
We will also be monitoring movements in interest rates. In part, we will be
tracking how the yields and spreads on the various assets that banks use to meet their
LCR requirements evolve. For example, to the extent that some banks will wish to keep
meeting a significant portion of their LCR requirements with reserves, the reduction in
the Fed’s balance sheet and the associated drop in aggregate reserves could eventually
result in some upward pressure on the effective federal funds rate and on yields of

14

For a discussion of the overall effects of the decline in the Fed’s balance sheet, see Jane Ihrig, Lawrence
Mize, and Gretchen C. Weinbach (2017), “How Does the Fed Adjust Its Securities Holdings and Who Is
Affected?” Finance and Economics Discussion Series 2017-099 (Washington: Board of Governors of the
Federal Reserve System, September), https://www.federalreserve.gov/econres/feds/files/2017099pap.pdf.

- 14 Treasury securities. This situation could occur if some banks eventually find that they
are holding fewer reserves than desired at a given constellation of interest rates and, in
response, begin to bid for more federal funds while selling Treasury securities or other
assets. Interest rates will adjust up until banks are indifferent with regard to holding the
relatively smaller volume of reserves available in the banking system.
Overall, we will be monitoring to make sure that the level of reserves the Fed
supplies to the banking sector, which influences the composition of assets and liabilities
on banks’ balance sheets as well as market interest rates, provides the desired stance of
monetary policy to achieve our dual mandate of maximum employment and stable prices.
Of course, we will need to be very careful to understand the precise factors that underlie
any significant movements in these areas, because factors that are unrelated to the Fed’s
balance sheet policies might also cause such adjustments.
Conclusion
To conclude, I would like to reemphasize that I have touched on some highly
uncertain issues today--issues that, I would like to stress again, have not been decided by
the FOMC. One such issue that closely relates to my remarks today, and one I believe
the upcoming panel will likely address, is which policy implementation framework the
Fed should use in the long run. That is, broadly speaking, should the Fed continue to use
an operational framework that is characterized by having relatively abundant reserves and
operate in what is termed a “floor regime,” or should it use one in which the supply of
reserves is managed so that it is much closer to banks’ underlying demand for reserves as
in a “corridor regime”?

- 15 Of course, a host of complex issues underlie this decision, so I would just like to
emphasize two general points. First, a wide range of quantities of reserve balances--and
thus overall sizes of the Fed’s balance sheet--could be consistent with either type of
framework. Second, while U.S. liquidity regulations likely influence banks’ demand for
reserves, the Fed is not constrained by such regulations in deciding its operational
framework, because U.S. banks will be readily able to meet their regulatory liquidity
requirements using the range of available high-quality liquid assets, of which reserve
balances is one type.
Importantly, additional experience with the Federal Reserve’s policy of gradually
reducing its balance sheet will help inform policymakers’ future deliberations regarding
issues related to the long-run size of the Fed’s balance sheet, issues that will not need to
be decided for some time.
The final and most general point is simply to underscore the premise with which I
began these remarks: Financial regulation and monetary policy are, in important
respects, connected. Thus, it will always be important for the Federal Reserve to
maintain its integral role in the regulation of the financial system not only for the
visibility this provides into the economy, but precisely in order to calibrate the sorts of
relationships we have been talking about today.