The supply-demand mismatch in money markets garnered considerable attention this past September. We view the volatility having more to do with a lack of willingness or ability from banks to intermediate than a lack of cash in the system.
A temporary supply-demand mismatch for cash in money markets garnered considerable attention this past September. While the accompanying volatility was severe with repurchase agreement (repo) rates spiking to nearly 10% during intraday trading (Figure 1), it had more to do with a lack of willingness or ability of banks to intermediate than a lack of cash in the system. Simply put, banks were reluctant to reallocate into the repo market from reserves, due to liquidity regulations or to borrow from wholesale markets to lend into the repo market, due to capital regulations. Regardless of potential changes to monetary policy, we believe ensuring banks will be quicker to use their balance sheets and mitigate future funding mismatches will require changes to regulations. Improving repo market efficiency can be accomplished without compromising the resiliency of the banking sector.
September’s intraday repo market volatility drew similar headlines to 2008, yet the underlying circumstances could not have been more different. Rather than pervasive concerns around collateral values and counterparty credit risk, as was the case in 2008, September’s price action was driven by a handful of foreseeable and temporary factors impacting the supply and demand of cash. Though these episodes are similar in that banks hoarded liquid assets, the primary concern this fall was remaining in compliance with the myriad of post-crisis regulations and not lending to the wrong counterparty. This hindered intermediation in even the most liquid short-term funding markets, but the happenings were far from a Lehman Brothers moment.
If short-term cash markets had been efficient and rational in September, banks holding $1.45 trillion in reserves at the Federal Reserve (Fed)1 would have jumped at the opportunity to reallocate into a liquid, low-risk, substitute such as repo backed by Treasury collateral. Not doing so indicates that bank reserves, which are not scarce in the context of pre-crisis monetary policy (variance of only $25 billion relative to pre-crisis levels), have become scarce in the context of post-crisis liquidity regulations. While this volatility is not particularly new, as money market investors have seen regulatory-induced dislocation on display at critical quarter- and year-end time periods for some time, reserves reaching their lowest comfort level have exacerbated these challenges.
Why Banks Did Not Re-Allocate out of Reserves?
Investors have familiarized themselves with public liquidity regulations under Basel rules including the Liquidity Coverage Ratio (LCR) and the Net Stable Funding Ratio (NSFR), yet these ratios did not appear to be binding in limiting banks from participating in repo markets. LCR presented no hurdle for substitution, as both reserves and Treasuries are treated equivalently in the numerator as high-quality liquid assets (HQLA), while the NSFR has yet to be adopted or proposed in the United States2. Rather, it appears non-public liquidity requirements were more binding, including:
Key Takeaway Anecdotally, evidence suggests that regulators assign a higher monetization assumption on reserves relative to Treasuries for internal stress testing and resolution planning purposes, forcing banks to maintain higher balances.6 While treating reserves differently than Treasuries runs counter to the way these assets are viewed under the LCR, regulators likely prefer reserves since they can be used to make payments of unlimited size instantly as opposed to converting a large amount of Treasuries into cash which this takes time, may not be doable intra-day and can have a market impact7.
Why Banks Would Not Borrow to Intermediate?
New capital regulations have coincided with changes to binding capital constraints, making capital more expensive and scarcer. Under post-crisis rules, banks seek to use all capital that is always available to optimize returns. Negatively, capital cannot be as efficiently deployed if a dislocation hits.8 As it relates to repo markets, some of the most impactful changes post-crisis include:
Key Takeaway Post-crisis regulations incentivize banks to be smaller, particularly around quarter- and year-end. Doing so by reducing or de-emphasizing secured funding is efficient from both a G-SIB score and leverage ratio perspective. In September, if banks had decided to borrow in wholesale funding markets to finance repo lending opportunities, it would have resulted in a larger balance sheet with a corresponding negative implication on G-SIB score and returns.
Post-crisis bank regulations have created a more resilient banking system but a less efficient and less liquid financial market. With reserves having met their lowest comfortable level, the appetite of banks to intermediate in repo markets will depend on how bank rules and regulations evolve.
While changes to monetary policy could help the repo market, the Fed becoming a more regular market participant via a standing repo facility (SRF) is fraught with its own shortcomings. An SRF would not change regulatory-driven constraints in the banking sector, would present moral hazard and would be ironic given the focus of post-crisis regulations on preventing bank bail-outs, especially given the current stigma associated with the Fed’s Discount Window. 10
Unless changed, there are four important bank regulatory constraints impacting repo markets. Two relating to capital (leveraged capital ratios, G-SIB surcharge) and two relating to liquidity (resolution planning, intra-day stress test). While leveraged capital requirements currently have some momentum for potential modification by the Fed, the other constraints would still apply. 11, 12 We suggest two changes to post-crisis bank regulations that authorities can pursue to improve the resiliency of the repo market while maintaining the strength of the US banking sector:
1 Federal Reserve.
2 The LCR requires banks to hold high quality liquid assets (HQLA) sufficient enough to cover a projected 30-day net cash outflow under stress. It is calculated by dividing high HQLA by projected 30-day net cash outflows. For a bank looking to comply with the LCR, swapping excess reserves for treasury reverse repo merely exchanges one high quality liquid asset for another in the numerator of the ratio, leaving it unchanged. This compares to agency debt and agency MBS, which are treated as a relatively weaker form of HQLA under the LCR.
4 Source: Bank of America Merrill Lynch. Figure reflects estimate using NY Fed methodology for potential “day 1” potential stressed outflows across the 8 US G-SIBs.
6 During JPMorgan’s 3Q19 earnings call, CEO Jamie Dimon indicated that “..the requirement under CLAR and resolution recovery” has been necessitating an elevated amount of reserves held at the Fed relative to pre-crisis.
9 Source: Goldman Sachs Equity Research, “Americas Banks: G-SIB framework contributing to volatility in short term secured funding markets”, September 19, 2019. Includes, for example, reducing derivative notional exposures and selling non-core assets.
11 The Fed is contemplating the potential for the introduction of a Stress Capital Buffer (SCB) which would make risk-based capital ratios more binding. As per a recent speech by the Fed’s Vice Chair for Supervision Randy Quarles (https://www. federalreserve.gov/newsevents/speech/quarles20190905a.htm), leverage requirements could be removed from capital stress testing and only applicable on a spot basis.
12 Banks borrowing from a standing repo facility and relending that cash into the market will still result in pressure on the SLR and upward pressure in G-SIB score given it results in a larger balance sheet.
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