Unfair competition?

The Fed's credit-enhanced gift to flighty depositors, the RRP, needs attention.

““O ye'll tak' the high road, and I'll tak' the low road”

Friday headline: “Rally in bank stocks ahead as bank crisis appears contained.” I’m not sure the crisis can be considered contained until a source of financial instability has been addressed. On 31^st March, money market funds offered nearly 4.8%, thanks to the Fed’s RRP. Meanwhile, bank deposits typically offer less than 0.5%. US bank funding problems probably won’t disappear completely until depositors receive a competitive return. The RRP has become a financial stability issue. How will that gap be closed? Maybe cut rates or restrict access to the RRP. A less radical measure, though not especially pleasant, may require bank merger (or quasi-merger through ‘co-operation’, which creates its own issues). Now the Fed and the banks discover, late in the day, that Jeremy Stein was right all along; “monetary policy… gets in all of the cracks”, eventually.  As an interim palliative, here’s a photo of ample liquidity, taken from the ‘low road’.

Photo by Hency Parmar-Soni on Unsplash

Since early 2022 I have worried about the RRP; worried that it diverts liquidity from the banking system. It is a fair criticism to say that I never anticipated it would undermine the deposit base. I should have paid more attention to the discussion about the RRP design. The record reveals the Fed saw the RRP as competitor for bank deposits.

During the RRP design in 2013, financial stability concerns got an airing, including the effects on bank balance sheet funding costs. For all the care given to the design of the RRP, the policy response to COVID19 got in the way of the assumptions by setting off an inflationary fire. The resulting rate rise left deposit rates way behind and undermined the credit standing of banks.

The Fed always acknowledged that QE added costs to banks through forcing extra deposits into the system – leading to higher leverage requirements and deposit insurance. Banks made up the difference from the spread between Interest on Excess Reserves (IOER) and the deposit rate offered to clients. The more reserves in the system, the bigger the cost borne by depositors. What wasn’t expected was the scale of rate rises and the growing inability of bank business models to compete with the RRP. There is no doubt the RRP was needed to support control of short-term rates. What is at issue is the collateral damage to the banking system.

source: Federal Reserve

The 2020 ‘Dash for Cash’ both lit the inflationary fire and added (with stimulus checks) $2.7 trillion to bank deposits. Through 2021 the additional deposits migrated to money market funds, and the RRP rose from nil to $2.25 trillion. As rates rose in response to higher inflation, money market funds could offer both better returns and better credit. This threat to bank funding remains unresolved.

The model below is based on Fed discussion papers from 2013-2014. The assumption that the RRP rate would determine the deposit rate is explicit (RRP = R^Dep). That link proved tenuous. Deposit rates couldn’t keep up with RRP rates.

source: Federal Reserve, with author’s adjustments for clarity

The Fed did worry about facing money market funds and about financial stability implications. Specifically, “cash from liquid deposits could go into the RRP facility, availability of short-term funding could decline more quickly, additional flight-to-quality flows might occur, the financial stability implications would depend in large part on the firms that lose funding

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”. All these financial stability concerns are now present.

Some Fed insiders hinted the Fed could compete for depositors via the RRP: “the world is really changing, and it’s more of a capital markets world… 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.

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”

And again, the RRP as competitor to deposits was characterised in benign terms. “What you have now is depositors holding deposits at a bank and the bank holding reserves with us.  And what you’ll have instead is depositors putting funds with a money market fund, which is holding overnight RRPs with us.  There is no necessary implication for flows of funding to other folks in that structure.  As long as it happens smoothly—as long as it happens in a way that isn’t disruptive— I don’t think there is a reason to think that there are big losers.  I mean, there are losers because rates are higher, and people who used to issue CP at 20 basis points are now issuing CP at 50 basis points or something.”

That last sentence gives the clue to the pickle the Fed now finds itself in. The designers of the RRP, could not imagine a world in which CP needed to be issued at 5%, not 20 basis points. Liquidity is indeed ample, but it is in the wrong place with too much in money market funds, and a risk that even more heads that way with the result that bank funding issues continue.

A few very large US banks hold very substantial reserves at the Fed. These banks are in a good position to weather the storm. A number of other banks probably hope the Fed takes the most radical option and cuts rates or access to the RRP.

1. Supporting materials for FOMC meeting April 29-30, 2014

2. Transcript, FOMC meeting April 29–30, 2014