What ongoing repo turmoil means for banks

WASHINGTON — The Federal Reserve’s injection of billions of dollars starting in September seems to have stabilized an unsteady repurchase agreement market, but the banking industry could feel the repercussions of that intervention for some time.

On Sept. 16, the interest rate on overnight repo agreements spiked, surging from around 2% to over 10% before the Fed stepped in. The Federal Open Market Committee, which sets the central bank’s monetary policy, ordered the Federal Reserve Bank of New York to buy up to $75 billion in Treasury bonds in the repo market and authorized three issues of two-week repo transactions, up to $35 billion each.

But those transactions alone have not quenched demand for low-interest liquidity, and so the central bank has issued additional term repo offerings — most recently $25 billion worth of repo contracts last week eliciting $49 billion in bids.

Fed leaders have said repeatedly that they contained the damage from the repo spike.

“I think we have it under control,” Fed Chairman Jerome Powell told Congress last month. “We are prepared to continue to learn and adjust as we do this. But it's a process. I would say it is one that doesn't really have any implications for the economy or for the general public, though.”

But it may very well have important implications for banking and financial services, and it certainly has important implications for the Fed’s ability to enact monetary policy.

Cleveland Fed President Loretta Mester
Loretta Mester, president and chief executive officer Federal Reserve Bank of Cleveland, speaks during a Bloomberg Television interview at the Jackson Hole economic symposium, sponsored by the Federal Reserve Bank of Kansas City, in Moran, Wyoming, U.S., on Friday, Aug. 23, 2019. (Look for sentence from interview) Photographer: David Paul Morris/Bloomberg
What happened?
In the aftermath, Fed officials attributed the repo market spike to a confluence of unrelated factors.

The first is the central bank’s decision to begin slowly drawing down reserves in the financial system by allowing some maturing securities to expire. That initiative began in October 2017 and ultimately reduced the balance sheet from more than $4.5 trillion to just under $3.8 trillion in September.

Loretta Mester, president of the Federal Reserve Bank of Cleveland, said the FOMC sought to draw down its balance sheet while maintaining “ample reserves” — a level that would ensure a smooth monetary policy. But the spike suggests that the reserve level that the committee settled on was too low.

“We figured that level out with some analysis, but also asking the banks, ‘What reserve level would you be comfortable with holding? What's your minimum comfortable level?’ And then we added a buffer on top of that,” said Mester, who sits on the FOMC. “What we're in the process of doing is intervening in the market to bring that reserve levels up to where they were in the early-September time frame.”

Another factor was that banks began building up cash holdings to pay quarterly taxes due Sept. 16. And the Treasury’s auction for newly issued Treasury securities that same day siphoned additional cash away from the repo market, creating the conditions for uncommonly high demand for liquid cash.

Markets can experience unexpected volatility from time to time with little lasting effect. The 2010 stock market “flash crash,” for example, largely recovered within an hour. But the repo market is different, however. Not only is that market a critical cash conduit for banks and financial firms, but it is also a critical conduit through which the Fed conducts monetary policy.

Karen Petrou, managing partner at Federal Financial Analytics, said the Fed had little choice but to act fast because the repo market spike effectively threatened the central bank’s control over the federal funds rate.

“What the Fed is very frightened of — and why it's reacted the way it has — is that this means its monetary policy transmission channel is blocked,” Petrou said. “Something is happening that's changing interest rates and making them much less accommodative.”
Treasury Department building
The U.S. Department of the Treasury building stands in Washington, D.C., U.S., on Friday, July 29, 2011. President Barack Obama and congressional leaders began a fresh attempt to reach agreement on raising the U.S. debt cap, with a potential framework for a deal emerging two days before a default deadline. Photographer: Andrew Harrer/Bloomberg
Should the Treasury bank with banks again?
According to some observers, the repo spike also raises questions about the Treasury Department decision during the financial crisis to move its own deposit accounts from commercial banks to the Federal Reserve.

When banks paid taxes on Sept. 16, “all that money ended up at the Fed in that cash account and out of the financial system,” Bill Nelson, senior economist with the Bank Policy Institute. That could have contributed to volatility in the repo market.

The Treasury has a long relationship with the commercial banking sector as a client, but ever since the establishment of the Fed it has also had an account with the New York Fed, known as the Treasury General Account, or TGA.

The amount of reserves in that account has fluctuated over the years, but for the most part the majority of Treasury balances were kept in commercial banks to take advantage of better interest rate returns and to keep the Fed’s balance sheet relatively small.

But the Fed’s transition to using its reserve interest rate as its primary monetary policy implementation tool — combined with concerns about the financial stability of banks in the crisis — spurred Treasury to move almost all of its balances to the TGA.

Nelson said that meant less cash for banks to sink into to the repo market when it was needed most.

“Previously, what would have happened when that money flooded into the Treasury is it would have flooded right back out into the commercial banking system,” Nelson said. “So all those people are scrambling to get repo financing ... would have been met in large part by banks that had, in turn, received this inflow of funds that they needed to [invest].”

Marcus Stanley, policy director for Americans for Financial Reform, said that banks naturally would welcome back those Treasury deposits since they represent a low-cost source of funding. But the role that Treasury’s own deposits might play in the repo market volatility is just another example of how complex these markets are — and how small changes can have unintended effects.

“To me it underlines how much of an intricate plumbing problem this really is, and how the devil is in the details,” Stanley said. "This is the kind of thing that the Fed is trying to adjust to in its management of this market.”
Fed Chairman Jerome Powell
Jerome Powell, chairman of the U.S. Federal Reserve, delivers a speech at a conference to celebrate the 350th anniversary of the Riksbank in Stockholm, Sweden, on Friday, May 25, 2018. The central bank has embarked on an historic monetary easing program over the past years to bring back inflation, using a weaker krona to help achieve its goal. Photographer: Mikael Sjoberg/Bloomberg
Will repo scare convince regulators to revise liquidity rules?
Among regulators’ top priorities after the financial crisis was the need for banks to maintain greater levels of stable liquidity to reduce the risk of a crunch in an emergency.

To that end, the 2010 Basel III accords mandated that members of the G-20 implement both the Liquidity Coverage Ratio and the Net Stable Funding Ratio. Those rules were meant to keep both short-term and long-term liquidity flowing if traditional liquidity sources — such as the repo market — dried up.

While the NSFR has not yet been finalized in the U.S., the LCR has been in place since 2014 and requires banks to hold enough High Quality Liquid Assets, or HQLA, to fund operations for 30 days in a crisis.

The bulk of the HQLAs must be held as either cash or Treasurys — assets that are considered perfectly safe.

But some banks and regulators have said that those liquidity requirements have reduced the amount of liquid cash in circulation — and by extension in the repo market — and that regulators should reconsider the rules.

Treasury Secretary Steven Mnuchin said in October that he thought that a reconsideration of the post-crisis liquidity rules is “something that makes sense for regulators to look at."

“It’s a reasonable question: Have we gone too far in the other direction in requiring the banks to maintain this excess liquidity for intraday operations?” Mnuchin said.

But Powell retorted only days later that the Fed was not considering an adjustment to the liquidity rules. At that time, the reluctance of banks to invest more cash reserves in the repo market during the spike was perplexing. The Fed had consulted banks ahead of time on what an “ample” level of reserves would be, he said, and the market conditions on Sept. 16 didn’t portend a liquidity crunch.

“They were well above" the ample reserve level "and yet they didn’t deploy that liquidity when there seemed to be great opportunities to do that,” Powell said. “That didn’t happen, so why is that? We’re doing a careful analysis of that.”

The LCR doesn’t specifically dictate the amount of cash or Treasury a bank must hold, Nelson said. Banks theoretically can exchange one for the other and still remain in compliance with the rule. But he said in practice, examiners view cash as supremely liquid as it relates to complying with the rules.

Stanley said the idea that the liquidity rules are responsible for volatility in the repo market — or that changing the liquidity rules ought to be the Fed’s method of managing the repo market and monetary policy — is misguided.

“It’s very hard to judge that from the outside, because that’s the kind of thing you need to be in a supervisory relationship to be able to verify,” Stanley said. “But whatever real-world input there is, banks always come up with the same answer: Stop regulating us. It’s an error to say, ‘Let’s manage this by deregulating the big banks.’ ”
John Willams, President of the New York Fed.
What does it mean for the Libor transition?
One of the secondary effects of repo market volatility is the impact it could have on banks’ adoption of the secured overnight financing rate, or SOFR, as an alternative interest rate benchmark to the London interbank offered rate, or Libor.

The Fed, other regulators and market participants have been working in a partnership known as the Alternative Reference Rates Committee since 2014 to develop and implement an alternative to Libor in the wake of numerous rate-rigging scandals that emerged in 2011 and 2012.

The problem with Libor — which is based on the rate that banks lend to each other for overnight deposits — is that banks have gradually moved away from that mode of financing, and as a result there are fewer and fewer transactions to help determine the rate.

The ARRC identified the overnight repo market as the kind of deep, liquid overnight lending market that could serve as the basis for an interest rate benchmark similar to Libor. But regulators fear that the volatility in the market could discourage some banks and other financial institutions from adopting SOFR proactively.

New York Fed President John Williams has urged companies to move ahead with their post-Libor planning.

“As market participants make preparations to transition away from Libor, they’re understandably watching SOFR very closely,” Williams said. “My message to you is: Don’t let last month’s temporary spike in SOFR, or hope for the creation of some other replacement reference rate, become an excuse for delaying your transition away from Libor. I’ve said it before and I’ll say it again: Like death and taxes, the end of Libor is unavoidable, and we must do all that it takes to prepare for a Libor-less future.”

But Wayne Abernathy, executive vice president for financial institutions policy and regulatory affairs at the American Bankers Association, said the Fed’s intervention may lead to a long-term repo market distortion.

Speaking at a financial stability conference in Cleveland last month, Abernathy said the Fed’s repo intervention sent market participants the signal that whatever happens to the markets in the future, the agency will always be ready to intervene again.

“The Fed is stepping in to the tune of $100 billion a day to make sure there are enough reserves … to meet the needs of the repo markets,” Abernathy said. “I don’t think there has been enough evaluation of what that means with regard to expansion of the role of Federal Reserve into an area where it’s never been before.”

Petrou agreed, saying the move has undoubtedly sent the message to repo market participants that the Fed is standing by if the market spikes again, and that in turn makes SOFR in essence a government-controlled benchmark.

“It may preserve SOFR, but it's a different kind of benchmark,” Petrou said. “It's another piece of government control over the market.”
Federal Reserve building
A National Parks Service worker walks past the Marriner S. Eccles Federal Reserve building in Washington, D.C., U.S., on Wednesday, July 31, 2019. The Federal Reserve is widely expected to lower interest rates by a quarter-point at its meeting that concludes Wednesday and leave the option open for additional moves despite demands by President Donald Trump for a "large" rate cut. Photographer: Andrew Harrer/Bloomberg
Will bank capital requirements lead to more volatility?
The biggest challenge for the Fed in the coming weeks is whether it has injected enough liquidity into the repo market to stave off the same kind of market spike in December that occurred in September.

As in September, tax bills will come due later this month, again potentially creating the conditions for another round of volatility. And the conditions could actually be even worse, Nelson said, because the fourth quarter is when the largest banks are evaluated to determine the size of their so-called G-SIB surcharge — an additional layer of capital that the largest and most systemically important banks have to maintain.

“The G-SIB surcharge is measured almost entirely with year-end data,” Nelson said. “On the last day of the year, everybody that’s subject to the G-SIB surcharge around the world seeks to get smaller, and that particularly impacts the repo markets.”

Nelson said a similar crunch in the repo markets happened last year, when repo rates spiked to over 5% at year-end — a jump he attributed to the G-SIB surcharge rules.

In a Nov. 28 blog post, BPI economists suggested that if the Fed finalizes its Stress Capital Buffer rule before year-end and removes leverage-based ratios from the post-stress minimum capital requirements, “this by itself would immediately free up some capital that could be deployed for low-risk activities such as repo at year-end.”

Petrou said a broader long-term question is whether the Fed can continue to provide the kind of liquidity it is now providing to the repo market indefinitely. The core function of the repo market is exchanging Treasury securities — in other words, government debt — for cash. When the Fed injects cash into the repo market, they are buying government debt, and it remains to be seen whether the Fed can or should become the buyer of last resort for government debt.

“The Fed used to regulate the market and stabilize it through things like the discount window. Now it is the market,” Petrou said.
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