By Elham Saeidinezhad
The Fed is banking on non-bank intermediaries, such as money market funds (MMFs), rather than banks for monetary normalization. The short-term funding market reset after the famous FOMC meeting on June 16, 2021. The Fed explicitly brought forward forecasts for tighter monetary policy and boosted inflation projections. However, it is essential to understand what lies beneath the Fed’s message. Examining the “timing” of the Fed’s normalization and the primary “beneficiaries” unveils a modified FRB/US model to include the structural change in the intermediation business. Non-bank intermediaries, including MMFs, have become primary lenders in the housing market and accept deposits. In doing so, they have replaced banks as credit providers to the economy and have boosted their role in transmitting monetary policy. Following the pandemic, the timing of the Fed’s policies can be explained by the MMFs’ balance sheet problems. This shift in the Fed’s focus towards non-bank intermediaries has implications for the banks. Even though normalization tactics are universally strengthening MMFs, there are creating liability problems for the banking system.
A long-standing trend in macro-finance, the increased presence of the MMFs in the market for loanable funds, alters the Fed’s FRB/US model and informs this decision. The FRB/US model, in use by the Fed since 1996, is a large-scale model of the US economy featuring optimizing behavior by households and firms and detailed descriptions of the real economy and the financial sector. One distinctive feature of the Fed’s model compared to dynamic stochastic general equilibrium (DSGE) models is the ability to switch between alternative assumptions about economic agents’ expectations formation and roles. When it comes to the critical question of “who funds the real economy?” it is sensible to assume that non-bank financial entities, including MMFs, have replaced banks to manage deposits and lend. On their liabilities side, MMFs have become the savers’ de-facto money managers. This industry looks after $4tn of savings for individuals and businesses. On their asset sides, they have become primary lenders in significant markets such as housing, where the Fed keeps a close watch on.
Traditionally, two essential components of the FRB/US model, the financial market and the real economy, depended on the banks lending behavior. The financial sector is captured through monetary policy developments. Monetary policy was modeled as a simple rule for the federal funds rate, an interbank lending rate, subject to the zero lower bound on nominal interest rates. A variety of interest rates, including conventional 30-year residential mortgage rates, assumed to be set by the banks’ lending activities, informs the “federal funds target.” To capture aggregate economic activity, the FRB/US model assumed the level of spending in the model depends on intermediate-term consumer loan rates, again set by the banking system. The recent FOMC announcement sent a strong signal that the FRB/US model has been modified to capture the fading role of the banks in funding the economy and setting the rates.
One of the factors behind the declining role of the banking system in financing the economy is the depositors’ inclination to leave banks. Notably, most of this institutional run on the banking system is self-inflicted. After the pandemic, the Fed and government stimulus packages pointed to an influx of deposits that could enter the banking system. However, due to banks’ balance sheet constraints, managing deposits is costly for at least two reasons. First, the scarcity of balance sheet space implies banks have to forgo the more lucrative and unorthodox business opportunities if they accept deposits. Second, as the size of banks’ balance sheets increases, banks are required to hold more capital and liquid assets. Both are expensive as they reduce banks’ returns on equity. These prudential requirements are more binding for the large, cash-rich banks. Thus, post COVID-19 pandemic, cash-rich banks advised corporate clients to move money out of their firms and deposit them in MMFs. Pushing deposits into MMFs was preferable as it would reduce the size of banks’ balance sheets. The idea was that non-bank money managers, who are not under the Fed’s regulatory radar, would be able and willing to manage the liquidity.
Effectively, bankers orchestrated run on their own banks by turning away deposits. Had the Fed overlooked such “unnatural” actions by banks, they could undermine financial stability in the long run. Therefore, after the COVID-19 pandemic, the Fed expanded access to the reverse repo programs to include non-bank money managers, such as MMFs. In doing so, the Fed signaled the critical status of the MMF industry. The Fed also crafted its policies to strengthen the balance sheet of these funds. For example, Fed lifted limits on the amount of financial cash the companies could park at the central bank from $30bn to $80bn. The absence of profitable investments has compelled MMFs to use this opportunity and place more assets with the reverse repurchase program. The goal was to drain liquidity from the system, slow down the downward pressure on the short-term rates, and improve the industry’s profit margin. The Fed’s balance sheet access drove the MMFs to a higher layer of the monetary hierarchy.
The Fed might have improved the position of the MMFs in the monetary hierarchy. However, it could not expand the ability of the MMFs to invest the money fast enough. The mismatch between the size of the MMFs and the amount of liquidity in circulation created balance sheet problems for the industry. On the liabilities side, the money under management has increased dramatically as the large-scale economic stimulus from the Fed and the US government created excess demand for short-dated Treasuries and other securities. Therefore, assets in so-called government MMFs, whose investments are limited to Treasuries, jumped above $4tn for the first time. But, on the asset side, it was a shortage of profitable investments. The issue was that too much money was chasing short-term debt, just as the US Treasury started to scale back its issuance of such bills. This combination created downward pressure on the rates. The industry was not large enough to service a large amount of cash in the system under such a low-interest-rate environment.
The downward pressure on rates was intensified despite the Fed’s effort to include the MMFs in the reserve repurchase (RRP) facility. The dearth of suitable investments has compelled MMFs to place more assets with an overnight Fed facility. Yet, as the RRP facility paid no interest, it could not resolve a fundamental threat to the economics of the MMF industry, the lack of profitable investment opportunities. Once the post-pandemic monetary policy stance made the economics of the MMF industry alarmingly unsustainable, the Fed chose to start the normalization process and increase the RRP rates. The point to emphasize is that the timing of the Fed’s monetary policy normalization matches the developments in the MMF industry.
This shift in the Fed’s focus away from the banks and towards the MMFs yields mixed results for the banks, although it is unequivocally helping MMFs. First, the increase in RRP has strengthened the asset side of MMFs’ balance sheets as the policy has created a positive-yielding place to invest their enormous money under management. Second, other normalization policies, such as the rise in the federal funds rate and interest on excess reserve (IOER), are increasing rates, especially on the short-term assets, such as repo instruments. This adjustment has been critical for the smooth functioning of the MMFs as the repo rate was another staple source of income for the industry. Repo rate, the rate at which investors swap Treasuries and other high-quality collateral for cash in the repo market, had also turned negative at times. Overall, the policies that supported MMFs also improved the state of the short-term funding as the MMF industry plays a crucial role in the market for short-term funding.
The Fed policies are creating problems for the liabilities side of specific types of banks, bond-heavy banks. As Zoltan Pozsar noted, the Fed’s recent move to stimulate the economy through the RRP rate hurts banks’ liabilities. Such policies encourage large corporate clients to direct cash into MMFs. The recently generated outflow following the normalization process is being forced on both cash-rich and bond-heavy banks. This outflow is in addition to the trend above, where cash-rich banks have deliberately pushed the deposits outside their balance sheets and orchestrated the “run on their own banks.” The critical point is that while cash-rich banks’ business model encourages such outflows, they will create balance sheet crises for the bond-heavy banks, which rely on these deposits to finance their long-term securities. The Fed recognizes that bond-heavy banks can not handle the outflows. Still, the non-bank financial intermediaries have become the center of the Fed’s policies as the main financiers of the real economy.
The Fed is relying on non-bank intermediaries rather than banks for monetary normalization. To this end, the Fed has modified its FRB/US model to capture MMFs as the source of credit creation. The new signals evolve within the new monetary framework are suggesting that new identification is here to stay. First, the financial market echoed and rewarded the Fed after making such adjustments to assume financial intermediation. The market for short-term funding was reset shortly after the Fed’s announcements. The corrections in the capital market, both in stocks and bonds, were smooth as well. Second, after all, the Fed’s transition to primarily monitor MMFs balance sheet is less of a forward-looking act and more of an adjustment to a pre-existing condition. Researchers and global market-watchers are reaching a consensus that non-bank financial intermediaries are becoming the de-facto money lenders of the first resort to the real economy. Therefore, it is not accidental that the policy that restored the short-term funding market was the one that directly supported the MMFs rather than banks. Here’s a piece of good news for the Fed. Although the Fed’s traditional, bank-centric, “policy” tools, including fed funds target, are losing their grip on the market, its new, non-bank-centric “technical” tools, such as RRP, are able to restore the Fed’s control and credibility.