A monitoring committee led by global central bank officials said the expansion of central banks' balance sheets on an "unprecedented" scale in response to the 2008 global financial crisis negatively affected the functioning of financial markets, and laid out a nine-point list of best practices in case any such measures need to be used in the future.
A report prepared by a Markets Committee study group co-chaired by Ulrich Bindseil from the European Central Bank and Lorie Logan from the Federal Reserve Bank of New York said "little" prior experience with balance sheet expansion meant there were "significant" uncertainties surrounding the impact of such policies when central banks began using them during the global financial crisis.
Balance sheet expansion in the early phases had some positive effects on market functioning, such as mitigating severe funding market pressures and improving underlying liquidity, the report said. However, this led to some negative effects on market functioning which were in part contained by corrective measures enacted by policymakers.
Some of the negative effects included increased asset scarcity, falls in trading of reserves, decline in liquidity and "sharp" rises in bank reserves, according to the report. It warned that the use of "non-standard" tools for a prolonged period can bring about long-run changes in the bond market ecosystem, adding that these are slow to develop but slower to reverse.
"Lower trading volumes and price volatility, compressed credit spreads and flatter term structures may reduce the attractiveness of investing and dealing in bond markets," according to the report, which was published under the Bank for International Settlements' umbrella.
This could drive some players out of the market, leaving behind a more "concentrated" and "homogenous" set of investors, the report said, adding that this could lead to market malfunctioning as large central balance sheets are eventually unwound.
The report noted that there was some evidence of "adverse" impacts on market functioning when central bank holdings were particularly high, citing the example of Bank of Japan, which holds the largest share of government bonds relative to outstanding amounts. BoJ's balance sheet programs appear to have negatively affected government bond liquidity metrics, including trading volumes, it said.
The report laid out a nine-point list of "lessons" and "best practices" for minimizing negative effects on market functioning in case any such unconventional measures need to be used, including recommendations on a gradual pace of purchases, staying flexible and having well-designed securities lending programs.
The report complements another study by a working group which concluded that central banks effectively tackled the challenges presented by the crisis with negative interest rates, lending operations, asset purchase programs and forward guidance.
