The world's major central banks are preparing to normalize their monetary policy again: as important as this step is, it is not without risks for the financial system, which need to be monitored closely.

This is indicated by an economic study presented by finance professor Sascha Steffen from the Frankfurt School of Finance & Management together with colleagues and which attracted some attention at the international central bankers' conference in Jackson Hole, USA.

Christian Siedenbiedel

Editor in Business.

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The paper is called Why Shrinking Central Bank Balance Sheets is an Uphill Task.

Among others, the head of the American central bank, Jerome Powell, followed the analysis in Jackson Hole with interest - and wants to explore the consequences.

New phase of monetary policy

In an interview with the FAZ, finance professor Steffen explained his warnings.

It's about the following: The American Federal Reserve and the European Central Bank have expanded their balance sheets considerably in recent years through bond purchases.

Now they face the daunting task of reducing balance sheets by hundreds of billions of dollars and euros.

The American central bank is moving ahead, the European Central Bank is expected to follow with a slight delay, says Steffen.

"It's not as easy as many of those responsible think," says the finance professor. "The reduction in central bank balance sheets is associated with risks that are not yet sufficiently recognized."

The danger: Banks would become dependent on central bank liquidity and, if in doubt, they would have no choice but to support the banks with more and more money.

With the bond purchases, the central banks would have pumped liquidity, i.e. money, into the financial system.

"One could have expected that with this increase in liquidity, the deposits at the banks would increase in return, which could then simply be reduced again if the central bank withdrew liquidity," says Steffen.

"However, our investigations show that this process did not happen as one might have expected."

On the other hand, there has been a noticeable increase in so-called credit lines – these are, so to speak, promises from banks to companies that they will receive a loan if necessary at a previously agreed interest rate without further examination.

"From our observation, these credit lines are associated with risks for the phase in which the central banks withdraw liquidity from the markets," says Steffen.

Risk of liquidity crises

The phase around the Corona year 2020 has shown that it can happen that in crises many companies draw such credit lines at the same time, i.e. actually want to use the promised loans, reports the financial expert.

This process even increases if the individual companies know that many other companies now want to draw their credit lines - and liquidity could therefore become scarce.

"From our point of view, it is at least important to consider that such reasons can lead to liquidity crises in the banking system if the central banks reduce their balance sheets," warns the scientist.

In the euro area, banks in southern European countries may be exposed to greater risks than those in northern Europe in connection with the credit lines.

The consequence cannot be that the central banks refrain from normalizing their balance sheets, says Steffen.

"However, it seems important to monitor these risks, to react through banking regulation if necessary and to proceed cautiously when reducing central bank balance sheets."

In particular, however, the finance expert believes that if you want to use "quantitative easing", i.e. such bond purchases, in the future, you should take precautions to secure the financial system as early as possible when expanding the central bank balance sheet - such as the use of central bank liquidity by banks on certain conditions tie