Foreign banks in US made sharpest reserve cuts – Kansas Fed paper

Banks in the US responded with “considerable differences” to the Federal Reserve’s balance sheet reduction programme, research published by the Kansas Fed finds.

Blake March and Rajdeep Sengupta evaluate how banks adjusted their portfolios to the Fed’s balance sheet reduction programme, often referred to as quantitative tightening. They examine the period of 2014–19.

The Fed started reducing reserves in 2017 and ended in July this year. It reduced the level of total reserves in the system from roughly $4.5 trillion to less than $3.8 trillion.

The authors find reserve balances declined more steeply in systemically important banks and foreign lenders than they did for other banks.

Foreign banks experienced the steepest decline out of the three groups, they find. These banks initially held the most reserves, as lower regulatory costs meant they could better exploit the arbitrage opportunities between the “interest on excess reserves” rate and the federal funds rate, the researchers say.

Since 2015, the composition of assets on bank balance sheets has also changed, the authors find. In particular, systemically important banks have increased their holdings of US Treasury bonds, and to a lesser extent, of mortgaged-backed securities, they say.

They find the composition of asset holdings also “differs significantly” among the systemically important banks, “suggesting the drivers of demand for reserves are not uniform”. Bank of America, for example, holds a greater portion of mortgage-backed securities than JP Morgan, which holds relatively more government-issued bonds.