EcoFlash

The Fed’s new role under Basel 3

4
October 2019  
The Fed’s new role under Basel 3  
Céline Choulet  
On 16 and 17 September, US money markets seized up.  
Excess demand for cash pushed overnight rates sharply  
higher.  
Liquidity at any cost  
Rate at month end (%) and at 17 September 2019  
6.0  
5.5  
5.0  
4.5  
Secured Overnight Financing Rate (SOFR)  
The Fed had to step in as a matter of urgency to re-  
establish control over short-term rates by injecting central  
bank money through repurchase agreement operations  
(
repo).  
4
3
3
2
2
1
1
.0  
.5  
.0  
.5  
.0  
.5  
.0  
This lack of liquidity is not a new phenomenon. It is true  
that the situation was exacerbated by an irksome  
combination of factors. But there have been clear signs of a  
shortage of liquidity for more than a year now . The  
underlying issue is the regulatory liquidity requirements  
1
imposed on banks.  
The rebuilding of the Treasury current account with the  
Fed, against a background of insufficient reserves at the  
central bank, threatens further pressure. To relieve this  
pressure in a lasting way, the Fed will be forced to further  
expand its balance sheet and accept the role of dealer of  
first resort implicitly allotted to it by Basel 3.  
0.5  
0.0  
Mar-16 Sep-16 Mar-17 Sep-17 Mar-18 Sep-18 Mar-19 17S e p -19  
Figure 1  
Source: Macrobond  
money market funds was withdrawn as corporates prepared  
to pay their tax bills; the auction of USD 84 bn of Treasury  
securities was settled; and nearly USD 100 bn of T-bills were  
issued.  
One way to act quickly and without changing the size of its  
balance sheet would be to scale back its reverse repo  
operations with foreign central banks.  
Due to a lack of investor appetite for Treasury securities,  
primary dealers absorbed part of the excess collateral issued.  
The refinancing of their stocks of securities on the repo  
markets, against a background of insufficient central bank  
reserves, put significant pressure on money market rates. The  
In mid-September, for a number of one-off reasons, liquidity in  
the repo market dried up . Nearly USD 100 bn invested in  
2
1
C. Choulet (2018), Will central bank reserves soon become  
insufficient?, BNP Paribas, Conjoncture, December 2018  
A repo transaction  the temporary disposal of securities  can be  
considered, from an economics viewpoint, as a collateralised loan  
point in time for an agreed price. The interest rate, or repo rate, is a  
function of the difference between the sale and repurchase prices.  
The Fed defines the operation as a function of its effect on its  
counterparty. Thus from the Fed’s point of view, a repo is similar to a  
collateralised loan and recorded as an asset whereas a reverse repo  
is a liability. The repo markets are the main source of overnight  
refinancing for financial institutions in the USA.  
2
(cash against securities): from the point of view of the lender of the  
cash it is a reverse repurchase agreement; from that of the borrower  
of the cash it is a repurchase agreement. The repurchase agreement  
incorporates an undertaking to repurchase the security at a given  
EcoFlash // 4 October 2019  
economic-research.bnpparibas.com  
2
3
SOFR jumped to 2.42% on Monday 16 September and then  
to 5.25% on Tuesday 17 (Figure 1). This jump in repo rates  
EFFR, above the upper bound of the target range  
Rate at month end (%) and at 17 September 2019  
Effective Fed Funds Rate  
drew the traditional Fed fund lenders (the Federal Home Loan  
4
Banks ) away from the Fed funds market towards the more  
Fed Funds target range  
lucrative repo markets. The supply of Fed funds dried up  
whilst demand increased) and the Effective Fed Funds Rate  
EFFR) rose to 2.25% on Monday 16, taking it to the upper  
▪▪ Interest on excess reserves rate (IOER)  
(
(
2.75  
limit of its target range. The next day, Tuesday 17 September,  
it moved outside its range, reaching 2.3% (Figure 2).  
2
.50  
.25  
2
Substantial stocks in need of refinancing  
2.00  
1
.75  
.50  
Since 2018, the net position of primary dealers has increased  
significantly: by USD 110 bn between February and August  
1
2
018, then by USD 140 bn between October 2018 and  
1.25  
1.00  
January 2019, and finally by USD 75 bn between March and  
May 2019 (Figure 3). On 18 September, inventories stood at  
USD 230 bn (or nearly USD 315 bn if one includes agency-  
issued mortgage backed securities), more than twice their  
level between 2015 and 2017.  
5
0.75  
0.50  
0.25  
0.00  
Primary dealers are key counterparties for the US Treasury in  
all of its market activities. In particular their role is to take part  
in Treasury auctions, place securities and ensure the liquidity  
of the secondary market in Treasury securities. They do not  
have accounts with the Fed. They traditionally finance their  
purchases by drawing against their accounts with Bank of  
New York Mellon (BONY, the primary dealers’ clearing bank)  
and rebuild their balances with the bank as they sell the  
securities. The unprecedented increase in their stocks of  
securities has, however, forced them to increase their  
borrowing on the repo markets (mainly overnight) from  
commercial banks (primarily their parent companies), money  
Mar-16 Sep-16 Mar-17 Sep-17 Mar-18 Sep-18 Mar-19 1 7S e p -19  
Figure 2  
Source: Macrobond  
Collateral is proving hard to digest  
USD bn  
Net position of primary dealers in Treasury securities  
300  
start of  
tapering  
2
50  
00  
6
market funds, GSEs and BONY itself.  
2
Irrespective of the counterparties used by primary dealers on  
the repo markets (other than the GSEs, which have accounts  
with the Fed), the refinancing of their securities books results  
in a reduction in the reserves held by banks with the central  
bank. Where repos are conducted with non-bank  
institutions(with money market funds for instance), the banks  
150  
100  
yield curve  
inversion  
5
0
debit their clients’ deposit accounts and transfer cash from  
7
their own current accounts with the Fed to, ultimately , that of  
0
the Treasury. When banks themselves conduct repo  
transactions, the deal results simply in an asset swap, in the  
form of the recognition of a credit to the primary dealer (in the  
form of a repo) and a reduction in their reserves at the central  
bank.  
Sep-15  
Sep-16  
Sep-17  
Sep-18  
Sep-19  
Figure 3  
Source: Federal Reserve Bank of New York  
A shortage of central bank money  
The banks no longer have sufficient central bank money to  
play their part.  
3
The SOFR is a broad measure of the cost of borrowing cash  
overnight collateralised by Treasury securities on the tri-party repo  
market and on markets cleared through the Fixed Income Clearing  
Corporation (GCF repo and bilateral market). Volumes traded on  
these markets vary between USD1,000 bn and USD1,250 bn per day.  
As part of the reform of benchmark rates, it has been selected as an  
alternative to LIBOR to come into use by the end of 2021.  
Although central bank reserves stood at USD 1,385 bn at 18  
September, a level significantly above the volume strictly  
required under monetary policy (required reserves),  
everything suggests that they are close to the new minimum  
level needed to meet the regulatory liquidity requirements  
introduced under Basel 3.  
4
Credit cooperatives  
C. Choulet (2019), Primary dealers absorb nearly 40% of the Fed’s  
5
Since the introduction of the Liquidity Coverage Ratio (LCR)  
in 2015, banks must hold reserves (or more generally high-  
quality liquid assets  HQLA) sufficient to cover the net cash  
outflows over 30 days that would be triggered by a significant  
liquidity crisis (based on theoretical outflow or non-renewal  
rates as set by the regulator).  
net sales of Treasuries, BNP Paribas, Chart of the Week  
6
Mortgage guarantee and refinancing agencies  
7
Initially, subscription for securities by primary dealers results in a  
reduction in their credit balance with BONY, which transfers cash  
from its account with the Fed to that of the Treasury (to settle the  
purchases made by primary dealers). In a second phase, when a  
primary dealer puts securities into a repo with a bank (or one of its  
clients), there is a transfer of cash from the counterparty bank’s  
account with the Fed to BONY. The net result is that banks’ reserves  
with the Fed are reduced and the Treasury’s account increased.  
The central bank money requirements of the eight biggest US  
banks are all the greater because the regulator requires them,  
as part of their resolution plans, to be able to cover theoretical  
EcoFlash // 4 October 2019  
economic-research.bnpparibas.com  
3
cash outflows on an intra-day rather than merely daily basis.  
This constraint can only be met by holding large deposits with  
the central bank.  
USD bn  
Tools for reducing central bank liquidity  
Change in central bank reserves since October 2014  
At the time LCR was introduced, reserves were in particularly  
abundant supply (the automatic effect of the quantitative  
easing  QE  programme), but they have dwindled since. As  
QE came to an end in October 2014, banks had reserves with  
the Fed of more than USD 2,820 bn. Since then, monetary  
policy measures (reverse repo transactions, Fed balance  
sheet reduction programme), combined with the upward trend  
in money in circulation and issues of Treasuries, have  
reduced this stock. Over the last five years USD 1,430 bn of  
reserves have been destroyed. Some USD 620 bn has been  
destroyed by the reduction in the Fed’s securities portfolio,  
and USD 810 bn by the increase in other liabilities on the  
Fed’s balance sheet (Figure 4): cash in circulation  
Reductions in reserves through an increase in other Fed liabilities (cash  
in circulation, Treasury account, GSE and CCP accounts, reverse repos)  
Reductions in reserves through reduction in the Fed’s securities portfolio  
0
-200  
-400  
-600  
800  
-1000  
-
-1200  
-1400  
-1600  
(+USD 470 bn), the Treasury account with the Fed  
(+USD 200 bn), repos on the Fed’s securities (+USD 100 bn)  
and the accounts of GSEs and clearing houses (+USD 40 bn).  
For a number of years now, the US monetary authorities have  
sought to evaluate the extent to which liquidity requirements  
affect the aggregate demand for reserves. On 20 March, Fed  
Chairman, Jerome Powell, indicated that despite its efforts,  
the FOMC had not managed to come to a precise and  
detailed view on the topic: “The truth is, we don’t know. It may  
evolve over time. So we’ll just have to see.” On 18  
September, he acknowledged that uncertainty over reserve  
demand was still high.  
Figure 4  
Source: Federal Reserve, BNP Paribas  
A halving of the stock of reserves  
Reserves of the four biggest US commercial banks with the Fed, USD bn  
at 30 September 2017  
at 30 September 2018  
at 30 June 2019  
Although it is certainly difficult to evaluate with any accuracy  
banks’ need for central bank liquidity, we believe that tensions  
8
4
3
3
2
00  
have been visible for more than a year now . A range of  
symptoms bear this out: the increasing scarcity of cash  
50  
deposits’ from money market funds to the Fed (through the  
reverse repo facility, or RRP, which has been in place since  
013); the generous yields paid by banks on deposits from  
00  
50  
2
Federal Home Loan Banks; the swelling of primary dealer  
inventories; and the higher level of the EFFR relative to the  
rate paid on excess reserves.  
200  
1
50  
00  
50  
0
In the final quarter of 2018, the increase in primary dealer  
inventories came alongside a reduction in the reserves of US  
commercial banks of around USD 160 bn and an increase in  
net outstanding reverse repos and Fed funds loans of  
USD 166 bn (figures from FDIC Call Reports). Given the  
considerable concentration of reserves, the shock was  
absorbed in no small part by a single commercial bank, the  
largest of them, JP Morgan National Association. Its reserves  
with the Fed fell by USD 130 bn (from USD 275 bn in Q3 to  
USD 145 bn in Q4 2018), whilst its net outstanding reverse  
repo position increased by USD 110 bn (Figure 5).  
1
JP Morgan NA  
Wells Fargo Bank Bank of America NA  
NA  
Citibank NA  
Figure 5  
Source: FDIC Call Reports  
The Fed, dealer of first resort  
The Fed’s decision to interrupt the reduction in its balance  
sheet at the end of July rather than the end of September,  
and the more recent decision to inject central bank liquidity  
through temporary repo deals reflect increasing awareness  
of the restrictive nature of liquidity requirements.  
Between Wednesday 11 and Wednesday 18 September, the  
Treasury’s account with the Fed increased by USD 120 bn,  
reducing bank reserves by a like amount. It seems clear that  
the banks’ ability to absorb this shock was already too  
1
0
9
limited .  
10  
These transactions consist, for eligible counterparties (the primary  
dealers in this instance), in selling securities (Treasury debt  
securities, debt securities and mortgage-backed securities issued by  
the mortgage guarantee agencies) to the Fed with an obligation to  
buy them back at a certain point. From an accounting point of view,  
the securities remain on the balance sheets of the Fed’s  
counterparties. The Fed records the repo on its balance sheet as a  
credit to primary dealers and credits the banks’ current accounts  
8
C. Choulet (2019), Pressure on central bank liquidity is going  
undetected, BNP Paribas, Eco Flash, April 2019  
9
In Q2 2019, central bank reserves represented 33% of HQLA at the  
8
biggest US banks, from 43% in Q3 2017 (before the Fed’s balance  
sheet reduction).  
EcoFlash // 4 October 2019  
economic-research.bnpparibas.com  
4
Since 17 September, overnight transactions have been  
conducted with primary dealers each trading day (the volume  
of each daily transaction was capped at USD 75 bn between  
On 30 Sept., the Fed lent USD 200 bn of liquidity…  
Fed outstanding repo operations, USD bn  
Cash allocated (overnight and term repo operations)  
▪▪ Aggregate operation limit  
1
7 and 25 September, at USD 100 bn from 26 to 30  
September and then at USD 75 bn from 1 October). In  
addition, three 14-day term transactions have been conducted  
300  
(the first was capped at USD 30 bn, the second and third at  
USD 60 bn). The liquidity “lent” by the Fed is charged at a rate  
no less than the IOER interest on excess reserves rate (1.8%  
since 19 September) for overnight deals and IOER plus  
250  
200  
5
basis points for longer deals. This system will remain in  
11  
place until at least 10 October . Adding together overnight  
and term repos, the outstanding liquidity lent reached  
USD 202.5 bn on 30 September (Figure 6).  
1
50  
00  
50  
0
1
Granted, the Fed has reduced the risk that the specific needs  
of participants, at the moment that they close their quarterly  
accounts, would yet again lead it to lose control of short-term  
rates. However, the system it has put in place is only intended  
to be temporary, whilst there is a risk of a resurgence of  
tensions on multiple occasions. Most notably, the Treasury’s  
plans to rebuild its account with the Fed to USD 410 bn by the  
1
7
18  
19  
20  
23  
24  
25  
26  
27  
30  
Sept. Sept. Sept. Sept. Sept. Sept. Sept. Sept. Sept. Sept.  
Figure 6  
Source: FRBNY, BNP Paribas  
1
2
end of the year (from USD 303 bn on 18 September) could  
be a source of new tensions. This might suggest that to bring  
these tensions under long-term control, the Fed will have to  
Their outstanding value reached a record high of USD 306  
billion on 18 September (Figure 7). This is hardly surprising  
given the very attractive rates available on such deals. In the  
second quarter, the Fed paid a rate of 2.42%, equal to the  
average EFFR and slightly higher than the yield on 1-month  
securities. The Fed does not communicate regularly on the  
1
3
introduce a permanent repo system .  
The paradigm governing monetary policy has shifted.  
Previously, when central bank reserves were abundant, the  
Fed was required to step in to mop up excess liquidity through  
reverse repo deals. Today, due to the shortage of reserves,  
the Fed is required to inject central bank money.  
15  
rate offered , but given recent increases in rates, we would  
wager that yields remained very attractive in the third quarter.  
Although the introduction of liquidity rules sought to make the  
banking system less dependent on the central bank in times  
of crisis, it has paradoxically increased that dependence in  
normal times. Over and above its established role as lender of  
last resort, the Fed must now take on the mantle of the  
liquidity provider of first resort (through the regular conduct of  
repo transactions or the constitution of a large portfolio of  
securities).  
We believe that maintaining these high rates is unjustified for  
three reasons. First, since the beginning of 2019 it has  
created a distortion in the range of rates paid on cash  
deposited with the Fed. Treasury and GSE current accounts  
do not earn interest; cash lent by money market funds to the  
Fed (under RRP reverse repos) earns 1.7% (2% prior to the  
latest rate cut announced on 18 September); and bank  
deposits (reserves) receive 1.8% (2.1% prior to 18 September  
Figure 8).  
The means to increase reserves are at hand  
Secondly, such transactions seem inappropriate against a  
As we wrote in April, the Fed does have another tool in its  
locker. This would consist of capping the volume of reverse  
repo transactions with foreign central banks (FRRP) and/or  
the interest rate on such deals.  
1
6
background of excess collateral . Reducing their yields (or  
introducing a cap) would help redirect foreign central bank  
liquidity towards Treasury securities.  
For several years now, these transactions have made a  
1
4
significant contribution to the draining of reserves .  
(
central bank reserves), whilst the banks credit the deposit accounts  
(
reserves) by the same amount, such that the transaction has no  
of their clients. All other things being equal, on completion of the  
effect on the size of its balance sheet.  
transaction banks’ reserves with the central bank are increased.  
1
5
1
1
Whilst the Fed provides detailed information on repo and reverse  
https://www.newyorkfed.org/markets/domestic-market-  
repo transactions with private counterparties (volumes demanded,  
range of rates offered), it is much less forthcoming regarding reverse  
repo transactions entered into with foreign central banks. It does not  
publish continuous information on the interest rates for these  
transactions. It only provides the average rates for the first quarter,  
first half and first nine months of each year when it publishes its  
operations/monetary-policy-implementation/repo-reverse-repo-  
agreements/repurchase-agreement-operational-details  
1
2
By borrowing an additional USD 381 bn on the fixed income markets  
in the fourth quarter  
https://home.treasury.gov/news/press-releases/sm743)  
(
1
3
Z. Pozsar (2019), Design options for an o/n repo facility, Global  
Money Notes #25, Credit Suisse Economics, September 2019, 9.  
(unaudited) quarterly financial statements. We have extrapolated  
1
4
quarterly estimates on the basis of these data.  
As foreign central banks do not have accounts with the Fed, these  
1
6
Although between 2015 and 2016 these operations helped ease  
transactions transit through bank balance sheets. In return for the  
reverse repo operation with a foreign central bank, the Fed reduces  
the stock of reserves of the intermediary commercial bank, which in  
turn debits the dollar current account of its client (the foreign central  
bank). The Fed records the foreign central bank’s debt on its balance  
sheet (reverse repo) but reduces its debt to the banking system  
tension in the yields on Treasuries (nudging foreign central banks  
towards Treasuries at a time when money market funds were forced  
to increase their exposure to government debt), under current  
circumstances (high issuance levels of short-dated Treasuries) they  
look unjustified.  
EcoFlash // 4 October 2019  
economic-research.bnpparibas.com  
5
Above all, in a situation of scarcity of central bank money, it is  
counter-productive to offer this facility. The Fed’s systems  
result in the daily injection of at most between USD 200 bn  
and USD 250 bn into banks’ current accounts, through repo  
transactions , whilst at the same time destroying nearly  
USD 300 bn in reserves each day through reverse repo deals  
with foreign central banks.  
… whilst destroying nearly USD300 bn in reserves  
Fed outstanding reverse repo transactions, USD bn  
with money market funds (RRP)  
with foreign central banks (FRRP)  
1
7
700  
6
00  
00  
Reducing the scale of these transactions would allow the Fed  
to free up space on its balance sheet for banks (without  
expanding its balance sheet further) whilst it defines more  
precisely its needs in “organic growth”, according to the Fed’s  
terminology.  
5
400  
300  
200  
100  
0
Céline Choulet  
celine.choulet@bnpparibas.com  
Sep-12 Sep-13 Sep-14 Sep-15 Sep-16 Sep-17 Sep-18 Sep-19  
Figure 7  
Source: Federal Reserve  
Attractive returns on FRRP  
Quarterly average interest rate, %  
Secured Overnight Financing Rate (SOFR)  
▪▪ Interest on excess reserves rate (IOER)  
Rate on Fed reverse repos with money market funds (RRP)  
Rate on Fed reverse repos with foreign central banks (FRRP)  
2
2
1
1
0
0
.75  
2.5  
.25  
2
.75  
1.5  
.25  
1
.75  
0.5  
.25  
0
Figure 8  
Source: Macrobond, Federal Reserve, BNP Paribas  
17  
The maximum offered on daily overnight operations (USD 100 bn)  
and the three 14-day term operations (USD 150 bn).  
QUI SOMMES-NOUS ? Trois équipes d'économistes (économies OCDE, économies émergentes et risque pays, économie bancaire) forment la Direction des Etudes Economiques de BNP Paribas.
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