Hard to shift, easy to reshape: central bank reserve demand and frictions

Mathias Drehmann and Xuewen Fu

No 1372, BIS Working Papers from Bank for International Settlements

Abstract: How far can central banks shrink their balance sheets? The answer sets the limits to quantitative tightening (QT), and depends critically on the demand for reserves and whether the drivers widely thought to have increased it over the past decade actually do so. We assess the impact of three such drivers: post-crisis liquidity regulation, monetization frictions, and fragmented interbank markets. Building on the canonical Poole (1968) model, we show that these drivers tend to reshape, rather than horizontally shift, reserve demand. Liquidity regulation, such as the Liquidity Coverage Ratio (LCR), does not raise reserve demand when banks can substitute reserves with other high-quality liquid assets (HQLA). Over some regions of the curve, the LCR even reduces demand. Frictions in monetizing non-reserve HQLA into reserves change both the slope of the reserve demand curve and the satiation point when demand flattens. With fragmented interbank markets, the mapping from aggregate reserve supply to the interbank rate becomes non-unique. In this case, the effective reserve demand curve also shifts outward on impact of negative supply shocks, and the more so, the greater the initial level of supply. These findings have direct implications for balance sheet normalization, especially for central banks operating floor or ample reserves frameworks near the satiation point of the reserve demand curve.

Keywords: reserve demand; balance sheet normalisation; Liquidity Coverage Ratio; interbank market fragmentation; monetary policy implementation (search for similar items in EconPapers)
JEL-codes: E41 E43 E52 E58 G21 G28 (search for similar items in EconPapers)
Date: 2026-08
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