Now, balance sheet normalization involves reducing the private sector’s holdings of one type of LCR HQLA, reserves, and increasing others—Treasuries and agency MBS—by an equal aggregate amount, so normalization does not make HQLA writ large more scarce. 25 However, within the universe of HQLA, reserves are especially liquid: they can be used to make payments at any time without the need to sell or finance an asset in financial markets, which in a stressed environment might be difficult or costly. As a result, as the aggregate stock of reserves declines over balance sheet normalization, competition among banks may intensify for ways to bolster their measured liquidity position. 26 Such increasing competition could affect money markets by increasing the differential between different types of money markets borrowing based on its treatment under the LCR. The LCR determines a bank’s expected cash outflows by multiplying the outstanding balances of various categories of liabilities by various supervisory “runoff rates,” which are meant to reflect the relative “stickiness” of that type of liability. 27 Borrowing cash in overnight wholesale markets from another financial institution, such as a bank or a money market mutual fund, does not help a bank’s liquidity position as measured by the LCR, because the rule assumes this funding completely runs off during periods of financial stress. 28 However, borrowings from certain other kinds of lenders, such as public-sector entities, foreign central banks, and 24  Potter, “Discussion of ‘Evaluating Monetary Policy Operational Frameworks’ By Ulrich Bindseil,”August 26, 2016.

Staff at the Federal Reserve has been using new data sets, analytics, and extensive market intelligence to deepen our understanding of the impact of these changes on money market dynamics. What follows is an illustration of this enhanced understanding. In the pre-crisis monetary policy framework, banks’ regulatory obligation to hold reserves was primarily driven by the required reserves framework, set forth in the Federal Reserve Act and Regulation D. 21 This framework involved banks meeting their requirement over a 14-day reserves maintenance period, as well as various other incentives that promoted short-term, but not extremely high-frequency, bank balance sheet management activity to maintain reserves at required levels—and the Federal Reserve had built analytics to provide good visibility into it. Today, while the Regulation D framework is still around, it is no longer likely to be the binding constraint on reserve levels for most large banks. 22 The new factors driving reserves demand appear to vary by financial institution, and seem to depend on a complex interplay of numerous new features of the financial system. On the regulatory side, these include the Liquidity Coverage Ratio (LCR), banks’ internal stress tests of their liquidity adequacy, supervisory expectations related to banks’ ability to monetize their liquidity portfolios during periods of financial stress, and the incorporation of liquidity into resolution planning. Other important factors include increased bank aversion to incurring intraday overdrafts, higher bank investor and creditor expectations for liquidity, and a lower opportunity cost of holding reserves relative to before the crisis.