Keep liquidity provision loose during shocks – ECB study

Central banks should provide liquidity during periods of macroeconomic shock to prevent larger-than-necessary effects pummelling economies, a study by the European Central Bank (ECB) concludes.

The research bulletin by Davide Porcellacchia and Kevin Sheedy says that during shocks, banks increase their demand for liquid assets, such as US Treasuries, thereby pushing up the assets’ prices.

During such periods, the liquidity premium – the cost of holding liquid assets – also begins to play a role, the authors say. However, the study finds that central banks with elastic liquidity policies can reduce this premium by 15 basis points when shocks occur.

Meanwhile, the funding spread – the rate at which banks borrow without collateral, minus a risk-free rate – is reduced by 30bp. This, in turn, is accompanied by an increase of around 2% in the total amount invested in the economy.

A shock makes it more expensive for banks to secure short-term funding and alerts depositors, who may rush to withdraw their assets. This would put banks in even greater danger of collapsing, the authors show.

The effects then ripple into the broader economy as banks tighten their lending, the authors say.

Central banks should therefore be loose in their provision of liquid assets, such as Treasuries.

The authors show that pessimism increases the effect of a shock event on the value of bank assets by about a third, and prolongs the effect.