Global reset – Monetary decoupling (Part 2: Economics of large central bank balance sheets)

Global reset – Monetary decoupling (Part 2: Economics of large central bank balance sheets)

Phuah Eng Chye (3 July 2021)

Massive sterilisation and QE programs have enlarged central bank balance sheets to disproportionate sizes. Stephen Cecchetti and Paul Tucker notes “in 2007, the central banks in the US, euro area, UK, and Japan had total assets ranging from 6% to 20% of nominal GDP. By the end of 2020, the Fed’s balance sheet was 34% of GDP, the ECB’s 59%, the Bank of England’s 40%, and the Bank of Japan’s 127%”.

Central bank balance sheets have also grown disproportionately relative to the banks they regulate. As a matter of comparison, the Fed’s[1] total assets amounted to about $900 billion in September 2008. By December 2008, it reached $2.2 trillion or roughly the size of JP Morgan Chase. Fed total assets reached $4.5 trillion in 2016 and $7.4 trillion in 2020 while JP Morgan Chase’s[2] total assets lagged, amounting to $2.5 trillion and $3.4 trillion respectively.

The Bank of International Settlements (BIS) set up a study group to review “Large central bank balance sheets and market functioning”. The study group noted central banks expanded their tools “to address financial market dislocations and the limitations of interest rate policy as rates approached their effective lower bound, many central banks introduced special lending programmes, often followed by large-scale asset purchase programmes”.

The BIS study group cautioned that “while adverse effects have often been transitory, they can have an enduring impact when policies are in place for a prolonged period. Negative effects on market functioning have tended to be associated with elevated asset scarcity, in particular when central bank purchases or securities holdings were particularly large in relation to issuance or outstanding amounts…Scarcity at times has led to deterioration in bond liquidity metrics and increased repo specialness, although these effects were often short-lived. Declines in market making and reduced investor participation were reported in some markets, in particular where policies were in place for an extended period of time. Hence, the consequences for market functioning may not be fully evident until balance sheets normalise”.

The BIS study group also reported “the expansion of central bank balance sheets produced sharp increases in bank reserves, contributing to a significant decline in interbank reserves trading activity. However, activity in wholesale money markets has remained robust, and central banks have kept a sufficient degree of control over short-term interest rates…Some market functioning spillovers have also been observed in bond markets, both positive and negative, although, in practice, such effects have been neither persistent nor broad-based. In money markets, experience suggests that the dollar funding costs in FX swap markets, and associated cross-currency basis spreads, merit monitoring as they could potentially indicate more widespread dysfunction in international money markets. For example, during the acute phases of the GFC and the euro area crisis, the elevated costs of obtaining dollar funding through FX swaps was reflective of broader funding market disruptions. Central bank lending programmes and liquidity swap lines eased adverse market functioning spillovers and helped to contain the basis. In contrast, the persistent cross-currency basis observed in recent years reflects divergent monetary policy stances coupled with more limited arbitrage capacity post-crisis, rather than any underlying market dysfunction”.

The BIS Study Group concluded that “previously, their balance sheets generally reflected, in a passive way, demand for central bank liabilities as well as the framework used to conduct conventional monetary policy. Since then, a number of central banks have come to view their balance sheets as an active tool for crisis management and monetary policy implementation when policy rates are near their effective lower bound.

Before the crisis, as shown, central bank balance sheets grew much more in lock-step with currency in circulation (an autonomous factor) as well as with GDP. This changed markedly when asset purchases and unconventional lending operations became widely used from 2008 onwards. The aggregate size of the balance sheets of these central banks more than quadrupled, in stark contrast to more moderate growth in currency in circulation and GDP”.

Exploring a theoretical framework

The important role of central bank balance sheets has been magnified by their enlargement. Traditional monetary theory and regulatory policies become obsolete as large balance sheets distort indicators such as money supply or the money multiplier. In particular, large central bank balance sheets have underpinned financial innovation, changed monetary dynamics and transformed the financial landscape. There is a need to review monetary theory and regulatory policies for the impact of large central bank balance sheets in several areas.

First, sterilisations and QE increase the proportion of short-term to long-term financial assets in the central bank balance sheet. In this regard, textbooks explain sterilisation from the perspective of managing domestic monetary conditions and regard sterilised reserves as passive because central banks are limited to investing only in high quality and liquid foreign assets (usually sovereign debt). Generally, these balance sheet interventions are “temporary” and quickly unwound, the effects are minimal. In practice, central banks found it difficult to normalise[3] their balance sheets (reduce sterilisation and QE assets). The short-term financial assets[4] therefore end up having a permanent effect.

My hypothesis is that central bank short-term assets function as feedstock for market liquidity. Specifically, central bank forex reserves act as high-powered collateral supporting the leverage of cross-border carry trades. During the first decade of the millennium, massive Asian central bank sterilisation relieved the Fed from expanding USD money supply but sterilisation had a multiplier effect that generated massive international demand for USD (that caused global shortages of safe assets). The massive demand for safe assets underpinned the growth of the global fund management industry and an expansion in the range of investible assets (such as synthetic and bundled products). Intermediaries facilitated substitutability among assets (especially safe assets) and calibration of portfolio and risk strategies (including hedging and leverage). This strengthened connectivity between different asset prices and markets. Overall, the large quantities of central bank short-term assets underpinned the global liquidity that underpinned low interest rates and buoyant asset prices around the world.

Second, changes in relative balance sheet sizes transformed the financial landscape and the positions of different players. Between the 1990s to 2010s, the global banks had the largest balance sheets and dominated market activities. The global banks, rather than markets, acted as the main conduits of connectivity, and aggregators of risks across assets and markets. The financial landscape has been transformed as central banks and the asset management industry have surpassed the biggest banks in terms of balance sheet assets. This means central banks and the large asset managers are displacing global banks as the most Systemically Important Financial Institutions (SIFIs). With their large balance sheets, central banks and large asset managers dominate markets. They can no longer act as passive price-takers and effectively have a major role in facilitating connectivity and aggregating risks.

The logic of regulating institutions with a large systemic footprint should therefore be extended to them. This includes them explicitly taking over some responsibilities from intermediaries for pricing risks and promoting orderly market conditions. It should be noted there are differences between the market-making roles of private intermediaries and central banks. Private intermediaries take on market-making obligations in return for preferential treatment in relation to order flow, trading costs and leverage with profit objectives. In contrast, central banks need to align their market-making activities towards promoting financial stability, improving economic efficiency (minimising friction costs to participants) and promoting market discipline.

Third, large central bank balance sheets have altered the role of policy rates.  Large central bank balance sheets skewed in favour of short-term assets and zero-bound interest rates incentivises the use of leverage and a broadening in the range of investible assets to enhance returns. This results in a shift in asset price equilibriums from a position reflecting unlevered returns to one reflecting leveraged returns. Thus, policy rates now have a significant role in balancing the returns to savers with the flow of private sector credit into markets. Policy rates changes triggers portfolio re-allocation across asset markets. A fall in policy rates increases leverage (of investments) and cause asset prices to rise. A rise in policy rates decreases leverage and trigger an unwinding of trades that cause asset prices to fall.

Large central bank balance sheets thus tighten the linkages between policy rates, market liquidity, the rate of returns and asset prices. As linkages between policy rates and market liquidity tighten, its connectivity with economic activities, credit availability, risks and valuation benchmarks diminish. Hence, large central bank balance sheets act as a wedge that disconnects monetary policies from the economy.

Fourth, large central bank balance sheets amplify certain types of risks and shift the locus of these risks to the central bank. As central bank balance sheets expand, it unleashes short-term liquidity that forms asset price bubbles. Today, as mainstream equities and bonds display characteristics of a late cycle advance, investors have broadened and are fuelling price bubbles in products such as IPOs, SPACs, Redditstocks, bitcoin and commodities. The potential flashpoints[5] for market dislocation are thus increasing.

In this context, the large balance sheets do not necessarily reflect the strength of the central bank. They reflect the inventory risks from market-making. In other words, the large balance sheets are red flags warning of illiquidity risks from “black swan” price shocks. This goes into the heart of the liquidity problem in modern markets; the fear that risks are concentrated among a small group of intermediaries that account for the bulk of active trading. In earlier decades, this referred to the global banks. Today, it refers to the central banks, large fund managers and heavily-traded products.

Overall, the large balance sheets of central banks position them at the centre of a financialisation process where asset prices become the dominant force influencing economic conditions. There is a need to reframe roles and policies in a landscape altered by the dominance of central banks and asset managers in markets and by growing connectivity between asset prices, portfolio flows, returns and information.

Implications for the future role of central banks

Given the monetary landscape changes and economic effects of pandemic, Stephen Cecchetti and Paul Tucker note “central banks found themselves responding to runs both on non-bank intermediaries and in critical financial markets…they substituted themselves for broken, frozen, or sclerotic private markets, and likewise tailored facilities to steer credit to particular sectors or regions. This is a world far beyond the textbook picture of central banks providing an elastic currency and serving as a 19th century style lender of last resort to sound banks. Consequently, societies need a new vocabulary for discussing what central banks do, and why”.

Stephen Cecchetti and Paul Tucker explains “looking at the various uses of the central banks’ balance sheets in recent years, we see significant flaws in the framework governing their actions. Their legal powers may be clear but, except in the case of monetary policy as traditionally understood, we see no regimes that clearly set out purposes, objectives, and constraints. This leaves the public and its representatives without adequate means to scrutinise what their central banks are doing”. They propose scoping the different types of balance sheet operations as follows:

First, monetary policy operations to influence aggregate spending should be clearly identified. “Whether something described as QE is always in fact QE as we define it – with the purpose of directly stimulating aggregate spending – is another matter. In fact, bonds might be purchased to keep a market open, fund the issuers (private or public), or finance investors and traders needing to raise cash”.

Second, lender of last resort facilities was traditionally extended to banks. “Today, there is a set of intermediaries, including broker-dealers, money market funds, and others, that engage in bank-like activities offering demandable liabilities backed by less than completely liquid assets without direct access to the central bank. Recent experience suggests they will receive help when they come under stress”. “Whatever the merits of different approaches – who has access to liquidity support, and on what terms – central banks should make clear what they are willing to do: a credible, transparent, and explicit regime beats a series of improvisations. If non-banks are to have access, then there should be an open standing facility, but with regulatory constraints. If not, there must be structural reforms to ensure the non-banks will never need to borrow from the central bank and investors do not treat their liabilities as safe”.

Third, market maker of last resort role to address liquidity problems in specific markets should be made explicit. “A properly constructed market maker of last resort must have a large capacity but might need to do little. And, if the market maker makes purchases, then they should be unwound once the target market is functioning again. In other words, this is not an investment or term-financing facility. When market maker of last resort[6]purchases are not unwound, the holdings must be serving some other purpose, which requires its own justification”.

Fourth, selective credit support or subsidised credit to favoured borrowers in specific sectors, regions, or firms. The risks of political pressure “underlines the need for a clear framework requiring supposedly independent central banks to make public what they are doing and why”. Fifth, emergency government financing to provide needed funds directly to government. Currently, to prevent abuse, there are legal restrictions on central banks directly financing government. But since that cannot be excluded in absolutely all circumstances, there should be a framework delineating how and when it may occur, including the central bank’s path back to independence afterwards. If this were in place, it might avoid the need to help government via QE”.

In my view, large central bank balance sheets raise critical questions about the future role of central banks. In this regard, large central bank balance sheets are themselves a symptom of unresolved imbalances and malfunctioning markets. In tandem with this, funds and products may become too big to fail and central banks increasingly find themselves as price setters or market makers and, in extreme situations, have to bear the risks of becoming the market. In the process, the central bank role thus changes from being the lender of last resort to banks to becoming the liquidity provider of last resort to funds.

If large central bank balance sheets are to become a permanent fixture, I agree central banks need to explicitly clarify their regulatory objectives and role within the context of their dominance in markets and the proliferation of products. For example, what rules would they follow to minimise their impact as large players on markets? In relation to this, how would they go about preserving the integrity of price discovery and ensure market discipline works? By being explicit, central banks would reshape market expectations on when and how they would provide intervention support. It is also an opportunity to revamp the framework for liquidity support to include enhancing central bank facilities, rewriting access and asset purchase guidelines, formalising the sharing of costs with funds and product issuers, addressing regulatory and data gaps, and establish an asset management company (AMC) to manage distressed or impaired liquidity assets (similar to AMCs for properties and loans).

Policy challenges

In response to the pandemic crisis, Bill English, Kristin Forbes and Ángel Ubide note “central banks acted quickly and aggressively, deploying a range of tools in a multidimensional strategy to address overlapping challenges…rate cuts and forward guidance…asset purchases to address widespread dysfunction in key financial markets…liquidity provision and credit support…and…regulatory easing (such as reductions in the countercyclical capital buffer and other reductions in requirements for liquidity and capital buffers) to ensure banks would not amplify the contraction in credit and liquidity to meet regulatory standards”. They noted “first, the existence of FX swap agreements helped central banks limit the tensions in FX markets…Second, the very fast and aggressive reaction by the main advanced economy central banks stabilised financial markets and contained risk aversion…Third, the general understanding that this shock was not caused by domestic imbalances or policy mistakes meant that financial market participants were less likely to withdraw capital in response to policy actions taken to support economies and even governments…Finally, many emerging markets had better macroeconomic and policy fundamentals than in past crises, such as smaller current account deficits (which reduce reliance on capital flows), larger reserve stockpiles, more flexible exchange rates, more credible inflation targeting regimes, and a greater ability to absorb sharp currency depreciations”. Nonetheless, several key policy challenges are looming.

  1. Balance sheet normalisation

The biggest challenge facing central banks is the normalisation of post-QE balance sheets once economies regain their footing. Jeff Black notes “the Group of Seven developed economies piled on about $7 trillion in debt last year as they spent heavily to fight the pandemic and prop up their economies. Central banks ended up owning much of that new debt”. A New York Federal Reserve Bank May report “projects that the balance sheet could rise by 2023 to $9 trillion, equivalent to 39% of gross domestic product. Under a range of scenarios, Fed assets could remain at that level through 2030 or drop as low as $6.6 trillion”. Jeff Black points out the ability of central banks to operate independently and to normalise their balance sheets are being hemmed in by unrealistic and political expectations. “The problem is that markets have come to expect central banks to use their buying power to smooth over any hint of trouble. Governments may be tempted to lean on monetary authorities to use it to keep borrowing costs low indefinitely. And activists now also call on monetary officials to use their firepower to fight inequality and even climate change…magnified the political profile of central banks, leaving them more exposed to entanglement in fiscal policy…called for the bonds on the European Central Bank’s balance sheet to be cancelled or turned into perpetual bonds that never get paid back. The idea that government debt has to be honored is coming under attack. We’re headed toward this sort of Modern Monetary Theory regime where the debt and free money supposedly have no consequences”.

Richard Koo notes Japan had difficulties in exiting QE and warns that others will face similar challenges in escaping the QE trap. He highlights the winding down of QE causes long-term interest rates to rise and “puts the brakes on the recovery and force the Fed to go slow again in an on-again, off-again policy that could easily continue for an extended period of time”. He notes “there is shockingly little theoretical research or debate on how to wind down QE…almost none have discussed the costs and risks involved…What has been missing all along is an examination of why economies have not recovered after central banks took interest rates down to zero”. In any case, balance sheet normalisation is now moot as central banks embark on an even bigger round of QE to help their economies cope with the pandemic devastation. Rather than explore normalisation, the more pertinent questions today are whether formal limits should be set on central bank balance sheet expansion and how monetary policy should be adjusted to manage the after-effects of pandemic stimulus and debt forbearance.

  • Negative interest rates and yield curve control

Negative interest rates arise from two conditions. First, negative interest rates would not exist if not for large central bank balance sheets. Negative interest rates are a global (sterilisation) rather than local (QE) phenomenon; an outcome from excess global short-term demand for safe assets. Second, negative interest rates are a function of portfolio (leveraged and hedging) strategies and cannot be analysed on a stand-alone basis. In this regard, negative interest rates exist in several European countries and Japan due to their reluctance to sterilise and the policy decision to rely on interest rates to stem capital inflows into their markets.

Assessments of the impact of negative interest rates have generally been unfavourable due to their adverse effects on traditional intermediation, its inability to bring about an economic recovery, its creation of moral hazards and the difficulty of normalising central bank balance sheets in the future. Nonetheless, Grégory Claeys cautions the ECB should “not rush before exiting unconventional monetary policies including negative rates. Even if negative rates proved to be ineffective, or insufficient to bring the economy to full employment, given the full pass-through between the deposit rate and market rates, it would be extremely dangerous to exit negative rates too soon as it could harm the post-COVID-19 recovery as well as destabilise European sovereign debt markets”.

Many critical questions remain outstanding. Are negative interest rates an aberration or here to stay? Are negative interest rates good or bad for the economy? Negative interest rates are generally perceived to represent a transfer of the costs of balance sheet management from the government and central banks to the private sector savers and intermediaries (banks, insurance companies, wealth managers, pension funds). It is possible to tap potential socio-economic benefits from negative interest rates? Some suggest negative interest rates should be viewed as a form of wealth or savings tax, or even interest-free banking and be used to improve income redistribution or even to fund innovative and social projects. There is also a need to review the concepts of savings, zombie companies and non-performing assets in a negative interest rate environment.

So far, negative interest rates have been confined to Europe and Japan. Whether it spreads to the US depends on the Fed’s decision which, by virtue of its balance sheet size, is able to exercise yield curve control[7]. The Fed is currently walking the tightrope between overdoing QE and pre-empting the risks of a sudden spike in interest rates. The Fed has allowed US interest rates to rise with the yield on 10-year Treasury notes tripling[8] to around 1.50%-1.70%. This reflects the Fed wants to avoid the negative interest rate policy conundrums faced by EU and Japan. In my view, negative interest rates are not appropriate for the US as it is the global reserve currency. In this regard, allowing US interest rates to go negative would endanger its safe asset status and unleash severe inflationary pressure with massive de-stabilising effects. Overall, the risk of policy miscalculations is growing. The Fed, as the last line of the global monetary defence, should not be the first one to crumble.

  • Captive markets

Large central bank purchases (of government and private assets) end up creating a massive inventory overhang that leads to illiquidity problems associated with captive markets. The problem of captive markets is strategic because the massive inventory overhang will impede efforts to nurture a private sector recovery and to restore market discipline – both of which are critical to ensuring a sustained economic recovery.

John Ainger notes Europe’s pandemic bond buying program could result in the European Central Bank (ECB) owning “43% of Germany’s sovereign bond market by the end of next year (2021) and around two-fifths of Italian notes, according to Bloomberg Intelligence. That’s up from around 30% and 25% respectively at the end of 2019”. Traders complain “trading volumes in bund futures have collapsed 62% since the ECB started buying bonds” and “concern is growing that Europe’s bond markets are being Japanified – effectively shut down by a single, dominant buyer”. In this regard, “Japan’s fixed income trading floors have been decimated over the last decade and the markets are so dead that sometimes not a single government bond trades in a day. Despite the fact that there is over $8 trillion of Japanese debt in existence, the Bank of Japan (BOJ) owns around half of it, and sometimes close to 90% of individual issues”.

Tatsuyoshi Okimoto relates the BOJ introduced an asset purchase programme in conjunction with the launch of its comprehensive monetary easing (CME) in October 2010 began to purchase Exchange Traded Funds (ETFs). “Initially, ETF purchasing operations were meant to be a temporary measure” but eventually “stockholdings through ETFs accounting for nearly 5% of the aggregate market value of stocks traded on the first section of the Tokyo Stock Exchange, the BOJ has now become the top shareholder of a lot of Japanese companies, prompting many to voice concerns about adverse side effects, for instance, from the viewpoint of ensuring the efficacy of stock pricing as well as corporate governance”. While BOJ has indicated the possibility of tapering its ETF purchases, “the BOJ’s ETF purchases in 2018 amounted to a record 6.504 trillion yen against the backdrop of the global stock market slump that began in October 2018, providing a reminder of just how difficult it can be to scale down the operation”.


The pandemic has extended the duration of economic lockdowns and the reality is that central banks cannot contemplate normalisation. Instead, they have to figure how to stretch their already large balance sheet to accommodate further fiscal spending. The critical question is whether the central bank still has the tools and room to intervene decisively to contain any potential fallout from events such as an interest rate spike, a currency run or a major credit default. Ultimately, policy-makers need to chart a path out of the depths of the pandemic recession. This will require global policy coordination. Unfortunately, due to the rising geopolitical tensions, monetary policies are beginning to diverge.


Bank of International Settlements (BIS) (October 2019) “Large central bank balance sheets and market functioning”. Report prepared by Study Group chaired by Lorie Logan and Ulrich Bindseil.

Bill English, Kristin Forbes, Ángel Ubide (3 June 2021) “Monetary policy and central banking in the Covid era: A new eBook”. Voxeu.

Grégory Claeys (June 2021) “What are the effects of the ECB’s negative interest rate policy?” Publication for the committee on Economic and Monetary Affairs, Policy Department for Economic, Scientific and Quality of Life Policies, European Parliament.

Jeff Black (26 May 2021) “Central banks face new balancing act with their huge asset piles”. Bloomberg.

John Ainger (10 December 2020) “One of the world’s top bond markets is slowly capitulating to QE”. Bloomberg.

Phuah Eng Chye (2015) Policy paradigms for the anorexic and financialised economy: Managing the transition to an information society.

Phuah Eng Chye (5 June 2021) “Global reset – Two whales in a pond”.

Phuah Eng Chye (19 June 2021) “Global reset – Monetary decoupling (Part 1: Sterilisation and QE)”.

Richard C. Koo (2015) The escape from balance sheet recession and the QE trap. Wiley.

Sage Belz, David Wessel (5 June 2020) “What is yield curve control?” Brookings.

Stephen Cecchetti, Paul Tucker (1 June 2021) “Understanding how central banks use their balance sheets: A critical categorisation”. Voxeu.

Tatsuyoshi Okimoto (13 June 2019) “The Bank of Japan’s exchange-traded fund purchases and implications for the future”. Voxeu.

Willem Buiter, Anne Sibert (13 August 2007) “The central bank as the market maker of last resort: From lender of last resort to market maker of last resort”. Voxeu.

[1] See

[2] See

[3] See Richard C. Koo.

[4] Including those created by the offshore multiplier from the multiplication of counterparty liabilities through round-tripping and leveraged carry trades.

[5] Interest rate hikes, funding or rollover risks and runs on funds are potential triggers for financial contagion.

[6] See Willem Buiter and Anne Sibert explains “following the stock market collapse of 1987, the Russian default of 1998 and the tech bubble crash of 2001, all that the key monetary authorities have done is (1) lower the short risk-free interest rate and (2) provide vast amounts of liquidity against high-grade collateral only, and nothing against illiquid collateral. The result has been that the resolution of each of these financial crises created massive amounts of high-grade excess liquidity that was not withdrawn when market order was restored and provided the fuel that would produce the next credit boom and bust…Lowering the risk-free rate is not the solution to any credit crunch/liquidity crisis problem. It only encourages further borrowing and leverage by those already excessively prone to such acts”. They argue the solution is for “the central bank has to become the market maker of last resort”. In this regard, central banks should focus its market maker of last resort function on illiquid collateral “for which the market had stalled and no market price was available”. This has the benefit of keeping markets functioning “with a much smaller injection of liquidity”.

[7] Sage Belz and David Wessel provides an overview on the debate on yield curve control.

[8] From its low of 0.533% in 8 September 2020. See