The new/old art of monetary stability
Reserve requirements for US banks make an unexpected return and may affect repo market
The financial system shifted to a collateralised model in the last 15 years. That shift gave repo the role of principal guarantor of financial stability. This paper by Fed staff is a fascinating glimpse of their Defence Against the Dark Arts of monetary disturbance in the new regime. The summary TL;DR is that financial system demand for liquidity is closely related to the total level of bank deposits. What? How? That’s very old-fashioned!
The Fed abandoned reserve requirements based on deposits in March 2020 when it announced “In light of the shift to an ample reserves regime, the Board has reduced reserve requirement ratios to zero percent effective on March 26, the beginning of the next reserve maintenance period. This action eliminates reserve requirements for thousands of depository institutions and will help to support lending to households and businesses.”
Au contraire. The paper referenced above argues the US commercial banking system of its own accord has created its own reserve requirements, irrespective of the wishes of the Fed. The new ample reserves system has commercial banks dictate to the Fed the level of reserves required. In the old days, the Fed did the dictating. Moreover, the paper suggests the new, self-organising reserve requirement is MASSIVE - up to US$3.3 trillion and likely more.
Stability of Fed Funds is the sine qua non for monetary control at the Fed. The paper has all the hallmarks of an internal policy document aimed at Open Market operations at the New York Fed. Reserve requirements have become a policy imperative, just not in the form we once knew them. Plus, the paper is used as an inspiration for the Bank of England’s reserve management policy, so central bankers beyond the Fed seem to confirm its conclusions.
The paper holds broader financial plumbing applications - notably into the repo market. The spread between Effective Fed Funds Rate (EFFR) and Interest on Reserves (IOR) is closely related to repo rates, and therefore effective monetary policy transmission.
Interesting, therefore, that the relationships outlined in the paper suggest that current levels of deposits are consistent with EFFR breaching IOR, so foreshadowing stress in repo markets.
The modelled signal accurately reflected the ‘Repo Crisis’ of September 2019, so we can’t dismiss it. Yet, actual EFFR-IOR shows no stress at all. My guess is the liquidity of the Fed Funds market is so poor the spread is no guide to monetary liquidity conditions at all. But the Fed will know better.
These days the Standing Repurchase Facility (currently 4.75% or the top end of the target Fed Funds rate) is designed to ensure the repo rate does not explode as it did in September 2019 when the Fed breached the ‘liquidity lower bound’ during the last QT cycle. But that facility is available only to primary dealers and a limited number of banks. Repo affects every financial player, not just banks. I’ll return to this in a later post.
Good conclusion Meyrick, I look forward to Part 2 :-) I may have mentioned that I work in collaboration with my colleague who writes under the pseudonym BOOM. We correspond often and he recently observed that daily Repo was merely standard CB operations to support commercial banks. He says:
"Central Banks bail out the entire commercial banking system every night at Midnight. That is their prime role in the scheme of things. They can do that by creating assets out of thin air (as contracts) denominated in the national currency and loaning them to the retail banks who need overnight money to balance their Ledger.
They can repurchase these assets as soon as the bank no longer needs the money. The assets are called "Repos" -- Repurchase Agreements. None of this is ever revealed to the general public -- and for good reason.
They are not constrained in these operations. The "money" involved never goes into the real economy -- it is all held as "Reserves" in the banking systems Balance Sheets.
This is how the Reserve Bank of Australia explains it -- but I don't agree with their use of the term "as a cash provider" -- because they are not providing Physical Cash (!) -- just electronic Ledger entries. [I call it money, perhaps incorrectly]
'The Bank's open market operations'. Repos offer a flexible instrument for the Bank to manage the total amount of outstanding Exchange Settlement Account (ESA) balances in the banking system so as to keep the cash rate as close as possible to the target set by the Reserve Bank Board. By executing repos with its counterparties in its open market operations, principally as a 'cash' provider [I would say 'money'], the Bank manages the aggregate of institutions' ESA balances. Consequently, the Bank is a major source of funding for the domestic repo market.
There are three things that can make a bank Bankrupt:
1. A Debt Default/Falling Asset prices event that reveals a LOT of bad loans in their Loan Book (1929)
2. Widespread Inter-Bank Fraud or Shadow Banking (2007/2008) (1929)
3. A Run on the Bank's deposits. (1929)
All three can be patched up by the central bank. They only let a bank "go" in rare circumstances when it is beyond repair. [Cue Credit Suisse]
They can create money like this until the cows come home -- because it never escapes into the real economy. A Prudent bank should NEVER go broke. The problem is in the human beings that inhabit banks and can make very bad loans and gamble with the depositors money, shareholders funds, retained profits etc etc. "Oversight" by the central bank is supposed to avoid this risk."
I guess the oversight was lacking in the case of SVB because it 'came out of the blue'. In my experience this is unlikely given the multitude of controls in place. It doesn't pass the smell IMHO. https://austrianpeter.substack.com/p/a-perfect-storm-the-money-crisis?s=w
Like you Meyrick I have been searching for some indicators which might give a heads-up to possible disruptions such as 16th September 2019. I wrote about it some time later: https://austrianpeter.substack.com/p/a-perfect-storm-the-money-crisis?s=w
As an aside: I wrote: "....growth is expected to slow sharply to 0.6% for 2023", This was from the OBR. Yet 9 months later OBR projects a 6% reduction in UK standard of living in 2023! I use this to illustrate that it might be fruitless to rely on published statistics.
Maybe Meyrick you might inprove my understanding?