The Fed, the Law and Deposit Flight

Time to revisit the boundaries of 'extraordinary policy'

“My only interest is that we identify what went wrong here.” Jerome Powell, press conference, 22nd March 2023.

The Fed chairman is a lawyer by training. The role that the Fed played in encouraging money-market funds to compete for bank deposits may yet allow Jay Powell a fresh opportunity to exercise his legal mind. If stress from lost deposits returns, the mutterings about the ONRRP may become louder legal questions. It may be hard to imagine aggrieved bank shareholders suing the Fed but questions in Congress to clarify what the Federal Reserve Act actually permits are likely.

Photo by Tingey Injury Law Firm on Unsplash

One of the great benefit of the dollar is its ‘assemblage’ of legitimacy, domestically and internationally; a legitimacy founded in large part on the dollar system’s accordance with institutional constraints. Central to those constraints was the legal limits on Federal Reserve policy.

Since 2007 the Fed has engaged in a range of ‘extraordinary policy’ programmes. The most ‘extraordinary’ was Quantitative Easing, which has always prompted claims that the policy confused fiscal and monetary policy and so flirted with legal limits of Fed action. QE made another extraordinary reappearance during the COVID19 panic, accompanied by another 13 new lending facilities. It has been said that “as many as seven (of these 13) credit facilities are in tension with section 13(3)(B)(i) of the Federal Reserve Act”.

Not surprisingly, the Fed challenges this interpretation arguing that section 13(3) was amended in the Depression specifically “to endow the Fed with the ability to lend directly to the real economy in an emergency.”  And the public (and the wider world) tend to agree with the Fed that ad hoc responses to financial crisis are warranted.

The difficulty is that the series of ‘extraordinary measures’ left a system whose novelty delivers unequal outcomes across society and multiplies uncertainty in forecasts. The delicate balance of legitimacy could be questioned. And what was seen as justifiable during a crisis may look considerably less so if it leads to unforeseen financial stability issues later. That seems to be where we are with bank funding issues and ONRRP.

It would not be surprising if members of Congress whose areas are affected by banking problems take an interest in the Fed’s role in recent banking difficulties. The issue would attract interest from a wide audience. The ONRRP allowed the Fed to accept quasi-deposits from money-market funds. The Federal Reserve Act stipulates that deposits are expected to come from ‘depository institutions’. Money market funds are not depository institutions, they are mutual funds that pay a variable dividend based on their investment returns.

From an operational point of view, ‘ample liquidity’ (i.e., too much liquidity) needed the ONRRP to absorb the excess or repo rates was fall below target rates. That became especially important after the suspension of Supplementary Leverage Ratio relief in March 2021, when banks became unwilling to face money market funds. And in any case, banks would have to compete with Fed ONRRP rate for money market funding. But the record shows the Fed knew the ONRRP would act as a competition for bank deposits. The record does not show the Fed gave much consideration to how offering deposit facility to money market funds in a steeply inverted yield curve could undermine deposits in the banking system.

The record also shows that FOMC members were quite happy, even keen, to challenge ‘depository institutions. As the ONRRP was being refined in 2014, Jeremy Stein commented: “The world is really changing, and it’s more of a capital markets world, and so what is money has changed in some fundamental sense… back in the day, we didn’t provide currency. The private banks provided bank notes, and at some point, the decision was made that that wasn’t all that good for financial stability, so we took that job away from the private sector. This, in some ways, would be a bit of a modern-day analogue to that.”  Someone may wish to ask the FOMC about if they still think money has changed so much that depository institutions can be actively damaged by Fed policies.

It is hard to imagine the deposit uncertainty can be fixed without removing the inversion of the curve or some radical curtailment of access to the ONRRP.  After a decade or more of ultra-low interest rates, banks had many low-yielding assets which placed a constraint on the willingness to increase deposit rates. That is entirely normal in a tightening cycle. Indeed, the restriction tightening places on banks’ balance sheets is how policy is transmitted into the economy. But the inverted yield curve added another damaging layer; market funds were transformed into a dangerous magnet for deposits on top of existing stress in banking profits.  Post-GFC reforms of money market funds exacerbated the competition because from 2016 onwards, par funds were forced to shift to government holdings. Combined with higher ONRRP rates the public had access to higher rates and better credit ratings in money market funds compared to banks. A toxic combination – if you are a bank.