by Dr. Charles Lieberman
Chief Investment Officer
Overnight repo rates (repurchase agreements) soared on September 13 to around 10%, which triggered an outpouring of concern that the financial system might suffer a meltdown similar to 2008. Now, almost two weeks later, the concern focuses on the Fed’s almost daily injections of funds into the overnight market, typically $75 billion at a clip, as if these activities signal major impending problems in the financial markets. In fact, they represent utterly normal activities, which were routine not that long ago and will soon be recognized as such again.
What are repo transactions?
Repos are nothing more than very short-term, collateralized loans. Most such loans are overnight, although one-week loans are also common. The collateral used is typically Treasuries, which makes these loans extremely high quality, although other high-quality collateral can also be used. In 2008, this market became dysfunctional as defaults caused a collapse of the mortgage market and the supply of safe Treasuries was insufficient to meet the needs of the market for collateral.
Where does the need for overnight loans come from?
Bank cash holdings satisfy legal reserve requirements, but cash positions fluctuate daily in response to actions of depositors and borrowers. For example, when a depositor withdraws $100 from his bank account, the outflow of deposits reduces required reserves by a small fraction of $100, but reserves decline by the full $100. The bank reserve position is now deficient. But when that $100 finds its way into another bank, it now has excess reserves (above its reserve needs) and it can lend that excess to the first bank on an overnight basis so that both can meet their respective reserve needs. This normal behavior has been disrupted by changes in the Fed’s policy whereby banks receive interest on excess reserves, which may discourage the second bank from lending those excess reserves to the deficient bank.
It isn’t just the movement of cash that can disrupt the supply of reserves at individual banks on a daily basis. Another sizable source of reserve fluctuations is the movement of Treasury deposits. When you pay taxes to the IRS, those funds are deposited in a Treasury account in the same bank used by the payer. My $100 check payable to the IRS against my account at Chase goes into the Treasury bank account at Chase. This results in no change to the bank’s holdings of deposits or reserves. But when Treasury writes a check to pay for something, those checks are written against the Treasury’s account at the Federal Reserve. To avoid depleting that account, Treasury regularly shifts dollars from its bank accounts at banks across the country into its account at the Fed. Those cash movements drain the entire banking system of reserves, which must be replenished to avoid creating a reserve deficiency across the entire banking system.
Prior to QE, the Fed had to actively monitor the banking system’s supply of reserves relative to the bank’s collective need for reserves on a daily basis. The research departments of the NY Fed and the Federal Reserve Board in Washington routinely supplied these reserve estimates daily to the Fed’s trading desk so it could actively intervene with repos or reverse repos to keep the supply of reserves at the targeted levels. Fed repo or reverse repos operations were common. (Full disclosure: the NY Fed unit performing these estimates reported to me when I was Head of the Monetary Analysis staff.)
Errors in these estimates were inevitable and shortfalls were covered by banks borrowing from the Fed’s Discount Window (Fed overnight lending). Banks are commonly reluctant to be seen borrowing from the Discount Window since it could be misinterpreted as indicating that the bank was forced to borrow from the Fed because it was unable to borrow from other banks. Such reluctance can always be overcome at a price. Especially at quarter-end or year-end, if reserves were scarce, the cost of overnight money could soar dramatically, sometimes getting to 20% or 30%. Invariably, some banks were willing to borrow what they needed at the Discount Window to avoid paying such egregiously high rates, even if just for a day or a weekend. In September 2019, the reserve shortfall occurred on a tax payment date on which a large Treasury bond issue also settled, both of which drained reserves from the banking system. This is nothing to be alarmed about.
Quantitative easing by the Fed beginning in 2008 vastly oversupplied the banking system with reserves, so banks could easily meet their reserves requirements. Banks no longer mind holding excess reserves since the Fed pays interest on such reserves. So reserve deficiencies haven’t been an issue for years. Now that the supply of excess reserves has been greatly reduced by the Fed’s runoff in its balance sheet, the market is reverting to its previous normal behavior. The Fed will need to engage in routine repo (or reverse repo) transactions to offset normal fluctuations in the supply of reserves in the banking system due to movements of cash, Treasury deposits, and other factors. And when the Fed’s reserve estimates err, as will happen routinely, an escape valve is needed to enable banks to avoid breaking the law. (Banks would not be breaking the law because they have done anything wrong, but because the Fed has miscalculated the banking system’s needs for the reserves and left the banks with a shortfall.)
Quarter-end is approaching in a few days and the Fed has come to appreciate that it now needs to monitor and supply sufficient reserves. (I suspect the Fed’s trading desk was caught by surprise a few weeks ago when repo rates surged.) So the Fed has been proactively supplying cash via the repo market, including repos with two-week maturities, to avoid any market dislocation. This is very much a learning (or relearning) experience for the Fed, so rates might still rise at quarter-end. But, this would be entirely normal.
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