How Have Banks Been Managing the Composition of High-Quality Liquid Assets?

Abstract

Banks' liquidity management practices are fundamental to understanding the implementation and transmission of monetary policy. Since the Global Financial Crisis of 2007-09, these practices have been shaped importantly by the liquidity coverage ratio requirement. Given the lack of public data on how banks have been meeting this requirement, we construct estimates of U.S. banks' high-quality liquid assets (HQLA) and examine how banks have managed these assets since the crisis. We find that banks have adopted a wide range of HQLA compositions and show that this empirical finding is consistent with a risk-return framework that hinges on banks' aversion to liquidity and interest rate risks. We discuss how various regulations and business model choices can drive HQLA compositions in general, and connect many of the specific compositions we see to banks' own public statements regarding their liquidity strategies. Finally, we highlight how banks' preferences for the share of HQLA met with reserves affect the Fed's monetary policy implementation framework.

Introduction

Liquidity management—ensuring access to sufficient quantities of assets that can be converted easily and quickly into cash with little or no loss of value—has always been a key component of banks' balance sheet management. However, liquidity management has become an even more important consideration in banks' operations in the wake of the Global Financial Crisis of 2007-09 with the introduction of new regulations aimed at ensuring banks' ability to meet their cash and collateral obligations during times of financial stress. In particular, beginning in 2015, large banks in the United States have needed to comply with the liquidity coverage ratio (LCR) by holding sufficient "high-quality liquid assets" (HQLA), a requirement that has induced significant changes to banks' balance sheet management. In this article, we examine how U.S. banks have managed the composition of their HQLA to meet the LCR and other liquidity considerations over the past several years. In particular, we address the following questions: Which particular liquid assets have banks chosen to hold and in what shares? Have those liquid shares changed over time? Do banks' preferences for these liquid shares vary? If so, what factors may be driving banks' preferences in this regard?

Understanding banks' liquidity management is central to both the implementation and the transmission of monetary policy. Banks' preferences regarding the compositions of their liquid pools—and in particular their demand for excess reserve balances—interact with various short-term market interest rates and thus the Federal Reserve's setting of its administered rates. In turn, the constellation of these interest rates affects banks' choices regarding the composition of their balance sheets—that is, the trade-off between lending and holding liquid assets—and hence the transmission of monetary policy (Bianchi and Bigio, 2017). In addition, we and others have noted that banks' preferences regarding the compositions of their liquid assets have influenced the Federal Open Market Committee's determination of "ample" reserves needed to effectively and efficiently implement monetary policy in the longer run; ultimately, these preferences affect the long-run size of the Federal Reserve's balance sheet.

Because no historical time series of HQLA are available, we begin our analysis by constructing bank-level, quarterly estimates of HQLA from 1997 to the present. We focus on the three largest components of HQLA—banks' reserve balances held at the Federal Reserve and their holdings of both Treasury securities and certain mortgage-backed securities (MBS). We use our bank-level estimates to document how U.S. banks have managed the compositions of their HQLA pools over time. Not surprisingly given the Federal Reserve's large-scale asset purchases (LSAPs) that injected reserves into the banking system at the time, we find that during the run-up to becoming LCR compliant, banks in aggregate took on a significant quantity of excess reserves. However, after becoming compliant, many such banks adjusted their liquid asset holdings, reducing their stocks of reserve balances and raising their holdings of other HQLA components, presumably to achieve a more optimal configuration.

To explain this subsequent compositional adjustment, we use a risk-return framework that captures the relative return of the different HQLA components, the covariance of these returns, and the sensitivity of banks' preferences for these assets to a metric of their risk aversion. One can think of this model as capturing the decisions of a bank's treasury department. The bank treasurer oversees investments in various securities and cash instruments while providing for the bank's daily liquidity needs and meeting regulatory constraints such as the LCR. In particular, in managing the bank's liquid assets, the treasurer considers liquidity risk—the risk that cash is not immediately available when needed—and interest rate risk—in this case, the risk that the value of a liquid asset will change due to a change in interest rates. Interest rate risk is a particular concern for holders of fixed-income securities such as Treasury securities. The more risk averse the bank is in this context, the more its treasury department tilts its bank's HQLA composition toward cash—that is, the more the bank prefers holding a relatively high share of reserve balances in its HQLA pool, helping to insulate it from both liquidity and interest rate risks.

With this model in hand, we then look at individual, bank-level data for the eight U.S global systemically important banks (GSIBs) based on publicly available sources. We find that the HQLA compositions of these large institutions differ widely, with some institutions relying on reserves and others more so on longer-term assets. This result holds even for some institutions with similar business models. Digging deeper with daily, bank-reported confidential HQLA data, we find that the volatilities of these banks' HQLA shares differ. In particular, we find that banks that exhibit a relatively higher level of daily volatility in their cash balances tend to rely more heavily on reserves to meet their liquidity needs.

We conclude that banks have different tolerances for exposure to liquidity and interest rate risks, and, based on research into individual banks' own descriptions of their liquidity management strategies, we identify a number of factors influencing their strategies. These factors include their individual evaluations of how they choose to meet post-crisis financial regulations as well as a range of other influences including differing business models, products and services, and unobservable, internal operating procedures. Where possible, we back up our empirical findings with specific public statements. For example, large banks have cited resolution planning requirements—which rely on bank-dependent stress-test models—as a key driver of their reserves share of HQLA.