Quantitative easing and the ‘hot potato’ effect: Evidence from euro area banks

Ellen Ryan, Karl Whelan 05 April 2019



Between late 2014 and the end of 2018, the Eurosystem of Central Banks accumulated about €2.5 trillion of assets via its asset purchase programme (APP), the ECB’s version of quantitative easing (QE) (for a discussion of the details of APP, see Demertzis and Wolff 2016). These assets were paid for by the creation of new money. Specifically, they were paid for by providing credits to the ‘reserve accounts’ that euro area banks hold with the Eurosystem. As a result, euro area banks have accumulated unprecedentedly high levels of reserve balances. 

Figure 1 uses bank-level data to show the distribution of euro area bank reserve holdings as a share of assets for January 2015 and May 2018. The share of banks holding reserves less than or equal to 1% of their total assets fell from 74% to 20%, and the share that was holding more than 5% increased from 6% to 47%.  

Figure 1 Changes in reserves-to-assets ratios of euro area banks

Note: Three outlier institutions are not shown for May 2018.

In a recent paper (Ryan and Whelan 2019), we examine the response of banks to this expansion in system-wide reserves. We want to know if banks passively absorbed this excess liquidity or if they actively tried to push it off their balance sheets. Banks could do the latter by creating new loans or by purchasing securities such as bonds. Either response would ultimately improve financing conditions to the real economy, with the latter operating more indirectly by lowering bond yields through a demand channel.

In the textbook money multiplier model, asset purchases by a central bank have an impact because of the introduction of excess reserves into the banking system.  In this model, reserves earn no interest and are considered an inferior asset to loans, so banks only hold the amount of reserves needed to satisfy reserve requirements.  By making loans, which are then re-deposited with other banks, the banking system as a whole translates an initial increase in reserves into a larger increase in the broader money supply. Reserves act like the ‘hot potato’ – nobody in the banking system wants to be holding excess reserves, so while the total supply of reserves doesn't change, the reserves end up being continuously passed around the system via their use in loan creation.  

The modern literature on QE has generally ignored this ‘hot potato’ mechanism. There are some good reasons for this. First, the implicit model of the banking sector underlying the money multiplier model ignores the fact that when making loans, banks need to consider demand for credit, default risk from creditors and regulatory restrictions on their balance sheets. Second, most modern central banks pay interest on reserves, thus reducing the opportunity cost associated with holding reserves and potentially eliminating the hot potato effect (Keister and McAndrews 2009). Indeed, money multipliers in the US, the UK, and the euro area dropped sharply following the introduction of QE, an outcome which is at odds with the predictions of a textbook money multiplier framework. The QE literature has instead focused mainly on the effect of changes in the net supply of bonds to the private sector in reducing bond yields, i.e. a portfolio rebalancing channel (e.g. Gagnon et al. 2011). 

Despite the weaknesses in the money multiplier framework, it is still worthwhile examining the possible role of reserve creation in the transmission of QE to the real economy. The assumption that banks passively absorb an increased supply of reserves, instead of pushing them off of their balance sheets and creating a hot potato effect, may not hold. It is worth noting as well that the ECB’s deposit facility rate was negative throughout the period studied. Charging euro area banks to hold excess reserves may have provided an increased incentive to pass these reserves on to other banks.

Using monthly bank-level balance sheet information for almost 200 euro area banks between 2015 and 2018, we do find evidence of a hot potato effect. But, unlike in the textbook model, we find that this effect is associated with the purchase of debt securities by banks instead of lending to the real economy.

One way to identify a hot potato effect is to ask whether we see any evidence of ‘churn’ in the holdings of reserves. We measure churn by comparing the sum of monthly changes in reserve holdings across banks (net changes) with the absolute sum of monthly changes in reserve holdings across banks (gross changes). This measure was originally proposed in a US context by Ennis and Wolman (2012) and has also been applied in a UK context by Butt et al. (2015). If the increase in reserves is being passively absorbed by banks, then we would expect to see a widespread increase in reserve holdings across banks, providing a ratio between these two measures roughly equal to one.  However, if individual banks are successfully pushing reserves off of their own balance sheets and onto the balance sheets of other banks, the ‘pushing’ banks will have negative month-on-month changes and the ‘receiving’ banks will have higher month-on-month increases. This will result in a ratio greater than one.  

Figure 2 shows that the gross changes far exceeded the net changes in reserves throughout our sample, with the gap widening over time. This suggests that banks with large amounts of reserves have been working to get rid of them.

Figure 2 Gross and net changes in reserve balances of euro area banks

Note: Measures are smoothed using a one quarter rolling sum

Figure 3 provides examples of the kinds of dynamics that are occurring at the microeconomic level to generate these patterns. It shows the reserves-to-assets ratio for three different banks that ended our sample at different points in the overall reserves-to-assets ratio distribution. We see that each of the banks experienced spikes followed by sharp declines in their relative holdings of reserves since late 2014. This behaviour is inconsistent with the assumption that banks passively absorb reserves. 

Figure 3 Reserve-to-assets dynamics for three euro area banks


Using regression analysis to examine the behaviour of individual banks, we find that banks with reserve-to-assets ratios above the system average in one period tend to move closer towards the average level in the following period.  However, unlike in the traditional money multiplier model, where excess reserves are used in loan creation, our evidence suggests that banks are primarily managing reserves through debt security purchases and by paying down a broad range of funding sources. As such, this hot potato effect seems likely to have had an effect in reducing European bond yields that is distinct from the portfolio rebalancing effect emphasised in the QE literature thus far.

Authors' note: Views expressed in this column are those of the authors and are not necessarily those held by the Central Bank of Ireland, the ECB or the European System of Central Banks. 


Butt, N, R Churm, M McMahon, A Morotz and J Schanz (2015), "QE and the Bank Lending Channel in the United Kingdom". CEPR Discussion Paper No. 10875.

Demertzis, M, and G Wolff (2016), “The effectiveness of the European Central Bank’s Asset Purchase Programme”, Bruegel Policy Contribution paper.

Ennis, H M and A L Wolman (2012), “Large Excess Reserves in the U.S.: A View from the Cross-Section of Banks,” Federal Reserve Bank of Richmond Working Paper Series WP 12-05.

Gagnon, J, M Raskin, J Remache, and B Sack (2011), “The Financial Market Effects of the Federal Reserve’s Large-Scale Asset Purchases”, International Journal of Central Banking 7: 3-43.

Keister, T, and J J McAndrews (2009), “Why Are Banks Holding So Many Excess Reserves?”, Federal Reserve Bank of New York Staff Reports, No. 380.

Ryan, E, and J Whelan (2019), “Quantitative Easing and the Hot Potato Effect: Evidence from Euro Area Banks”, CEPR Discussion Paper No. 13499.



Topics:  EU policies Financial regulation and banking

Tags:  QE, euro area, banks, asset purchases

Economist - Central Bank of Ireland

Professor of Economics, University College Dublin


CEPR Policy Research