Bill Nelson, Chief Economist and Head of Research at the Bank Policy Institute, stated in a report on Friday that by revising the U.S. liquidity framework, the balance of reserves banks hold at the Federal Reserve could be reduced by $2 trillion from the current level of approximately $3 trillion.
"Banks' demand for reserve balances, as well as the minimum size of the Federal Reserve's balance sheet required, could be significantly lowered. Very, very significantly," Nelson wrote.
Nelson estimated that modifying the U.S. liquidity regulatory framework to recognize borrowing capacity at the discount window, coupled with an "all-out" effort to eliminate the associated stigma, could reduce reserve requirements by $1 trillion.
Additionally, maintaining a modest positive spread between the repo rate and the interest rate on reserve balances (IORB) could further reduce demand by another $1 trillion.
"$3 trillion seems reasonable because reserve levels have roughly stabilized at this amount since 2022," Nelson wrote. "However, when the Fed decided to adopt a floor system at the end of 2018, staff informed Chairman Powell that only $1 trillion was necessary. Powell indicated he would regret the decision if it exceeded $1 trillion."
Two speeches on March 3 – one from Federal Reserve Vice Chair for Supervision Michelle Bowman, and another prepared for Treasury Secretary Scott Bessent – both called for a re-examination of bank liquidity regulations and the role of discount window borrowing in banks' liquidity risk management.
If liquidity regulations were to recognize discount window borrowing capacity, banks would not need to hold such high levels of reserve balances. If the demand for reserves decreases, the size of the Federal Reserve's equilibrium asset portfolio required to keep the federal funds rate aligned with the FOMC's target would also decrease by a corresponding amount.
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