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Only a Fed band-aid so far for what ails the money markets

admin | October 18, 2019

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors.

The sudden mid-September rise in repo and other funding rates has left money market investors worried about future episodes and convinced the Fed has only put a band-aid on the most obvious problems. That was the broad conclusion of the APS Funding Forum held in New York on October 16.

Insufficient bank reserves

The spike in overnight Treasury repo rates toward 10% on September 16 and 17 showed excess bank reserves probably fell at least $250 billion short of the right level, according to Lou Crandall, Chief Economist at Wrightson ICAP and a presenter at the forum. It also showed that liquidity for any Treasury portfolio was less than investors’ may have thought. A survey of primary dealers in March showed a median expectation of $1.2 trillion in required excess reserves. As of September 18, banks held $1.26 trillion in excess reserves, clearly not enough.

A number of things likely explain banks’ hesitation to move cash from their reserve accounts into Treasury repo. Bill Nelson, Chief Economist at the Bank Policy Institute and a former deputy director of the Fed’s Division of Monetary Affairs, pointed out during the forum that regulators have given special status to reserves in meeting bank liquidity requirements. While reserves and Treasury repo get equal treatment for satisfying the Liquidity Coverage Ratio, Nelson noted, reserves get better treatment in liquidity stress tests.  Regulators have argued that turning big blocks of Treasuries into cash through sale or repo to cover a same-day withdrawal would be difficult. Finding counterparties for a hundreds of billions in Treasuries in a stress market could be hard, and even the attempt could signal distress. A sale or repo attempt could trigger cascading fire sales through the financial system.

No bank wants to be short of sufficient reserves if a market suddenly seizes up, especially foreign banking organizations that borrowed from the Fed during the 2008 financial crisis and came under political pressure afterwards. If stress testing showed the bank could hit zero or go below on reserves, Nelson suggested, the head of the bank liquidity management team should expect two phone calls: one from the Fed to the bank CEO noting the bank is short, and another from HR asking the liquidity head to clear out his or her desk.

Limits to arbitrage

Nelson also argued that the largest banks today—the GSIBs—hesitate to do active funding arbitrage by borrowing at one rate in the fed funds or other market and lending at a higher rate in repo. That kind of strategy balloons the bank balance sheet and lowers capital ratios. If the borrower in an arbitrage trade is a foreign institution, the trade also pushes up the bank’s systemic risk score, which could trigger sudden jumps of up to 50 bp in additional required capital across the entire balance sheet.

Investors that borrow from the repo market said they had moved away from some assets that might be marginally harder to finance, and investors that lend into repo said they had tried to treat their usual counterparties fairly when the market has spiked.

But wait, there’s more

The challenges to money markets go beyond reserves, investors noted. “I think we have only 80% of this figured out,” one fund manager said.

One analyst noted the sharp rise in leveraged Treasury positions on primary dealer balance sheets.  The $225 billion in mid-September dealer balances marked a 44% rise from a year ago and 216% from two years ago. Primary dealers could just sell those positions and reduce the need for repo financing. But one analyst said anecdotally some bank dealers had put on total return swaps against those positions, forcing the dealers to keep holding and financing the positions.

The manager of one repo desk also pointed to other investors that habitually finance short and invest long. Another provider of repo funds cited the added operational demands of getting funds to a borrower quickly. “It’s not like buying a bond,” he said, highlighting operational friction in the ability to arbitrage across money markets.

A Fed band-aid on the problem

Fed efforts to add cash to the system through overnight and term repo and a program of heavy buying of Treasury bills starts to address the shortfall in reserves, but Crandall noted the market faces some key tests ahead where demand to borrow might outstrip the usual supply of cash. November 15, when the mid-quarter Treasury refunding settles, December 15, when a large Treasury auction settles, and December 31, when banks show balance sheets for regulatory purposes, will put pressure on rates.

A number of participants thought the Fed had put a temporary band-aid on the problem and will need to consider permanently higher levels of excess reserves, regular offerings of overnight or term repo or some relief to stress test liquidity requirements. Some thought informal relaxation of the preference for reserves would also help.

Crandall pointed out that Fed buying of bills along with SOMA portfolio reinvestment of MBS principal and other planned portfolio expansion would reduce net Treasury supply next year by $600 billion, also taking some pressure off the need to fund dealer inventory.

Despite plenty of speculation about a Fed standing repo facility, forum participants highlighted the tricky complications.  For banks, the Fed would need to set the repo rate above market levels to avoid vacuuming all repo business out of private markets. But the Fed would not want to set the rate so high that it looks punitive and triggers all the bad associations of going to the Fed discount window. That Goldilocks rate—not to high, not too low—could be tough to find. And borrowing from the Fed and lending to others would still balloon bank balance sheets and lower capital ratios. As for nonbanks, the Fed would run the risk of lending to weak or politically controversial borrowers.

The Fed for now looks focused on smoothing any immediate volatility in funding. But assuming the Fed can dampen concerns, it may need to revisit the ground rules for managing liquidity in a much more complex post-crisis market.