By Elham Saeidinezhad
“The secret of change is to focus all of your energy not on fighting the old, but on building the new” -Socrates
If the Fed’s understanding of the existing problems in the repo market is weak or incomplete, it might attempt to solve the wrong problems, and then implement the wrong solution. Financial participants and the Fed alike are trying to comprehend what triggered the short-term rates in the repo market to rise to 10 percent overnight from nearly 2 percent in September. The “liquidity shortage” that was created by the inaction of large banks to lend cash in the face of the excessive liquidity demands on that day is marked as one of the “triggers.” Since then, the Fed is seeking to tackle the liquidity shortage by lending cash to eligible banks and offering its own repo trades at target rates. Most recently, for example, the Federal Reserve Bank of New York injected $68.343 billion to the financial market on Friday, November 15th, in the form of repurchase agreements.
These large banks are intermediaries between the Fed and the rest of the system, and the idea is that they will re-lend this money in the repo market. Nonetheless, while the Fed is weighing the recent “triggering” stories, it might be approaching the issue with a wrong perspective. What we saw in the repo market in September has been a tragedy in the making as a result of both the Fed’s own “Tapering” that started in 2013 and the post-Crisis Basel III regulatory framework. The former reduced the number of reserves in the system while the latter put a strain on the balance sheets of the large banks and dampened their ability to lend to the market. Under these conditions, when the liquidity needs are higher than usual, the securities dealers, who are the main demanders of cash in the repo market, face a liquidity crunch. In the process, they put upward pressure on repo rates. The problem is that the Fed tends to overlook the balance sheet constraints that the banks face when examining the current developments in the wholesale money market. Once taking balance sheet restrictions into account, a more structural solution might involve opening the Fed’s balance sheets to the securities dealers.
To elaborate on this point, let us start by understanding the relationship between the interbank lending market and the repo market. The cash-rich lenders in the repo market are mostly hedge funds and other wholesale money managers, while the demanders for cash are securities dealers. The securities dealers use the repo market to finance their securities holdings while providing market-liquidity. Whenever the demand for cash is higher than its supply, banks enter the repo market to fill the gap by expanding their own balance sheet. Before the financial crisis, the banks used to finance these operations by using the Fed’s intraday credit facility and then settle these payments overnight by borrowing from other banks. After the crisis, banks stopped using these credit facilities to avoid being penalized by regulators. Regulatory requirements such as Liquidity Coverage Ratio (LCR), which requires banks to hold high-quality liquid assets, mostly reserves, limits the ability of large banks to engage in such operations due to the higher costs imposed on their balance sheets.
At the same time, the Fed’s Tapering reduced the number of reserves that these large banks are holding as a whole. The combination of these factors reduced banks’ ability to enter the repo market and lend on margin whenever there is a shortage of liquidity. In these circumstances, it should not be surprising that these banks did not seize the arbitrage opportunity when the shock hit the repo market in September even though they seem to be rich in reserves. The Fed’s tendency to discount the balance sheet limitations that the banks face when studying the current events in the repo market might prove to be costly. The Fed’s “taper tantrum” has reduced the number of reserves in the system while the regulations have created balance sheets constraints for large banks, who are the lender of the near-last resort in the repo market. These balance sheet restrictions lead to liquidity problems for the rest of the system and especially the dealers.
In a market-based economy, where the price of capital and collateral depends on the state of market-liquidity, the survival of the financial market depends on well-functioning securities dealers. These dealers create market-liquidity by financing their securities position in the repo market. Therefore, if the securities dealers’ access to the funding-liquidity becomes uncertain or very expensive at times, it might endanger the whole financial system. To sum up, given the recent structural changes in the financial ecosystem and banks’ business models, it might be time for the Fed to think about more structural solutions, such as opening its balance sheet directly to the securities dealers. After all, it is not accidental that the Fed’s continuous liquidity injections have not been entirely successful in stabilizing the repo market considering that the large banks have minimal balance sheet space to channel these reserves.
Discussion Questions:
- What was the main source of financing for large banks before the financial crisis? Did it change after the crisis?
- Why do Basel III regulatory requirements want banks to hold more liquid assets?