Tag Archives: Repo

U.S. Money Markets

For over a year the federal funds rate has increased relative to the rate the Fed pays on excess reserves. In mid September 2019, the federal funds rate increased abruptly, triggering the Fed to inject fresh funds. In parallel, the repo market rates spiked dramatically.

On the Cato Institute’s blog, George Selgin argues that structurally elevated demand collided with reduced supply. He mentions explicit and implicit regulation; Treasury General Account (TGA) balances; the NY Fed’s foreign repo pool (Japanese banks); and the administration’s $1 trillion deficit which required primary dealers to underwrite newly-issued government debt.

The bottom line is that regulators have managed to raise the biggest banks liquidity needs enough to compel them to sit on most of the banking system’s seemingly huge stock of excess reserves, and to do so even as repo markets present them with an opportunities to earn five times what those reserves are yielding just by lending them out overnight.

… So there you have it: a host of developments adding to banks’ demand for excess reserves, while others gradually chipped away at the stock of such reserves. Add a spike in primary dealers’ demand for short-term funding, a coinciding round of tax payments that transferred as many reserves to the TGA, and binding intraday liquidity requirements at the banks holding a large share of total system excess reserves, and you have the makings of last month’s perfect repo-market storm.

David Andolfatto and Jane Ihrig concur. On the Federal Reserve Bank of St. Louis’ On the Economy Blog, they already argued in March 2019 that banks feel compelled to hoard reserves rather than lending against treasuries:

Why should banks prefer reserves to higher-yielding Treasuries? One explanation is that Treasuries are not really cash equivalent if funds are needed immediately. In particular, for resolution planning purposes, banks may worry about the market value they would receive in the sale of or agreement to repurchase their securities in an individual stress scenario.

Consistent with this possibility, Federal Reserve Vice Chair for Supervision Randal Quarles noted, “Occasionally we hear that banks feel they are under supervisory pressure to satisfy their [high-quality liquid assets] with reserves rather than Treasury securities.”

To quantify this liquidity consideration, a recent post on the Federal Reserve Bank of New York’s Liberty Street Economics blog suggests that the eight domestic Large Institution Supervision Coordinating Committee’s banks collectively may want to hold $784 billion in precautionary reserves to cover their immediate liquidity needs in times of stress.

Andolfatto and Ihrig argue that the precautionary reserves hoarding by banks could substantially be reduced if the Fed offered a standing repo facility:

The Fed could easily incentivize banks to reduce their demand for reserves by operating a standing overnight repurchase (repo) facility that would permit banks to convert Treasuries to reserves on demand at an administered rate. This administered rate could be set a bit above market rates—perhaps several basis points above the top of the federal funds target range—so that the facility is not used every day …

With this facility in place, banks should feel comfortable holding Treasuries to help accommodate stress scenarios instead of reserves. The demand for reserves would decline substantially as a result. Ample reserves—and therefore the size of the Fed’s balance sheet—could in fact be much closer to their historical levels.

A standing repo facility could effectively impose a ceiling on repo rates. And as Andolfatto and Ihrig argue it would also have other benefits. In a follow up post, Andolfatto and Ihrig emphasize that,

[w]hile U.S. Treasuries are given equal weight with reserves in the calculation of high-quality liquid assets (HQLA) for the LCR, they are evidently not considered equivalent for resolution purposes.

Internal liquidity stress tests apparently assume a significant discount on Treasury securities liquidated in large volumes during times of stress, so that Treasuries are not treated as cash-equivalent. We have heard that banks occasionally feel under supervisory pressure to satisfy their HQLA requirements with reserves rather than Treasuries.

On the NewMonetarism blog, Stephen Williamson offers a longer-term perspective. He appears more skeptical as far as bank liquidity requirements as a possible explanation for the recent interest rate spikes are concerned. In Williamson’s view a floor system that requires even more reserves in the banking system than currently present is ineffective and should be replaced. He writes (my emphasis):

Before the financial crisis, the Fed intervened on the supply side of the overnight credit market by varying the quantity of its lending in the repo market so as to peg the fed funds rate. … a corridor system, as the central bank’s interest rate target was bounded above by the discount rate, and below by the interest rate on reserves, which was zero at the time. But, the Fed could have chosen to run a corridor by intervening on the other side of the market – by varying the quantity of reverse repos, for example. Post-financial crisis, the Fed’s floor system is effectively a mechanism for intervening on the demand side … With a large quantity reserves outstanding, those financial institutions holding reserves accounts have the option of lending to the Fed at the interest rate on reserves, or lending in the market – fed funds or repo market. Financial market arbitrage, in a frictionless world, would then look after the rest. By pegging the interest rate on excess reserves (IOER), the Fed should in principle peg overnight rates.

The problem is that overnight markets – particularly in the United States – are gummed up with various frictions. … Friction in U.S. overnight credit markets … is nothing new. Indeed, the big worry at the Fed, when “liftoff” from the 0-0.25% fed funds rate trading range occurred in December 2015, was that arbitrage would not work to peg overnight rates in a higher range. That’s why the Fed introduced the ON-RRP, or overnight reverse-repo, facility, with the ON-RRP rate set at the bottom of the fed funds rate target range, and IOER at the top of the range. The idea was that the ON-RRP rate would bound the fed funds rate from below.

… if total reserves outstanding are constant and general account balances go up, then reserve balances held in the private sector must go down by the same amount. The Fed permits these large and fluctuating Treasury balances, apparently because they think this won’t matter in a floor system, as it shouldn’t. … Another drain on private sector reserve balances is the foreign repo pool. … if the problem is low reserve balances in the private sector, those balances could be increased by about $300 billion if the Fed eliminated the foreign repo pool.

… The key problem is that the Fed is trying to manage overnight markets by working from the banking sector, through the stock of reserves. Apparently, that just won’t work in the American context, because market frictions are too severe. In particular, these frictions segment banks from the rest of the financial sector in various ways. The appropriate type of daily intervention for the Fed is in the repo market, which is more broadly-based. If $1.5 trillion in reserve balances isn’t enough to make a floor system work, without intervention through either a reverse-repo or repo facility, then that’s a bad floor system. … Make the secured overnight financing rate the policy rate, and run a corridor system. That’s what normal central banks do.

Some background information:

  • NY Fed commentary on monetary policy implementation.
  • Description (2009) of the primary dealer system, by Barry Ritzholtz.
  • NY Fed staff report (2015) on US repo and securities lending markets, by Viktoria Baklanova, Adam Copeland and Rebecca McCaughrin.

In the FT, Cale Tilford, Joe Rennison, Laura Noonan, Colby Smith, and Brendan Greeley “break down what went wrong, what happens next, and whether markets can avoid another cash crunch” (with many figures).

This post was updated on November 21, 11:09 pm; and on November 26 (FT article).

Collateral Values in ECB Operations

In the NZZ, Kjell Nyborg questions whether the collateral values of the securities the ECB accepts in monetary policy operations reflect market values. He argues that the valuation is discretionary and politicized.

Meine Analyse macht deutlich, dass der Besicherungsrahmen in der Euro-Zone in unterschiedlicher Ausprägung unter all diesen Problemen leidet. Das öffentliche Verzeichnis der zulässigen notenbankfähigen Sicherheiten enthält 30 000 bis 40 000 verschiedene Wertpapiere, von Staatsanleihen bis hin zu unbesicherten Bankanleihen und forderungsbesicherten Wertpapieren (Asset-Backed Securities). Die überwiegende Mehrheit dieser Wertpapiere hat keinen Marktpreis. Ungefähr ein Drittel all dieser Sicherheiten wird in nichtregulierten Märkten gehandelt. Zudem können Banken nichtmarktfähige Anlagen und Wertpapiere mit «privaten Ratings» verwenden, die nicht im öffentlichen Verzeichnis sind. Daher basieren die Werte der Sicherheiten mehrheitlich auf Modell- statt auf Marktpreisen. Interessanterweise ziehen Banken es vor, Sicherheiten zu benutzen, bei denen häufiger theoretische Preise verwendet werden. Generell tendiert die Besicherungspolitik der Euro-Zone zu risikoreichen und illiquiden Sicherheiten. Die untergeordnete Rolle des Marktes sieht man auch an der Häufigkeit, mit welcher die Sicherheitsabschläge für die Repo-Geschäfte des Euro-Systems aktualisiert werden: Dies geschieht lediglich alle drei bis vier Jahre.

Im Kern des Geldsystems in der Euro-Zone gibt es somit wenig Spielraum für Marktkräfte oder Marktdisziplin. Insgesamt kann die Besicherungspolitik des Euro-Systems als expansiv beschrieben werden. Die Liste notenbankfähiger Sicherheiten ist äusserst umfangreich und oft auf die «Bedürfnisse» von Banken in verschiedenen Ländern zugeschnitten. Sicherheiten können, zum Beispiel, durch Staatsgarantien aufgewertet werden. … Weil es im Kern des Euro-Geldsystems an Marktkräften und Marktdisziplin fehlt, entsteht ein Vakuum, das von anderen Kräften, wie Rating-Agenturen und der Politik, aufgefüllt wird.

… Ich dokumentiere, dass DBRS eine ausschlaggebende Rolle innehatte, indem sie über eine lange Zeit hinweg Italien und Spanien ein Rating von A– und Portugal ein solches von BBB– gab. Das hob den Wert der in diesen Ländern begebenen Sicherheiten um ungefähr bis 200 Mrd. € an und kann als unterstützende Massnahme für indirekte Bail-outs interpretiert werden.

Im Dezember 2011 und Februar 2012 hat die EZB eine ihrer wichtigsten geldpolitischen Massnahmen vor dem Beginn des Quantitative Easing implementiert. … Um aus dieser Möglichkeit Vorteil zu schlagen, hat die italienische Regierung gleichzeitig eine präzedenzlose Anzahl von Garantien für Bankanleihen mit niedrigem oder gar keinem Rating gesprochen. Damit erhöhte sie deren Besicherungswert. Darüber hinaus hat die EZB mehr als 10 000 unbesicherte, auf nichtregulierten Märkten gehandelte Bankanleihen der öffentlichen Liste notenbankfähiger Sicherheiten hinzugefügt, obwohl der aggregierte Wert notenbankfähiger Sicherheiten die Nachfrage von Banken nach Zentralbankgeld schon bei weitem überstieg.