EDITOR NOTE: An article that’s a bit more technical and convoluted than what our non-professional readers might be used to, this piece calls attention to the reduced bank reserves held at the Fed. So, what happens if banks don’t hold enough reserves? For one thing, they can’t lend as much, deflating the money stock. And if they get caught short upon a surge of withdrawals...well, you get the picture. Want the technical details? Keep reading.
The worst of the dollar funding crunch is over, for now. But as conditions improve in the financial system, the related decline in the total cash pile held by all banks at the US Federal Reserve should be carefully watched.
September’s blow-up in a key US short-term lending market was a stark reminder of the risks that a low level of bank reserves can pose to the global dollar funding market.
It is worth recounting how we got here. The coronavirus shock set off a dollar shortage around the world, as a significant contraction in lending denominated in the greenback by banks and non-banks failed to meet strong demand. The Fed acted quickly to rekindle swap lines with its overseas counterparts. And with the US economy contracting at a record pace, it pledged to provide an extraordinary level of support for the foreseeable future.
The medicine worked. The dollar and the cross-currency basis — a metric to gauge global dollar funding conditions — retraced back to their pre-pandemic levels, and the usage of central bank swap lines fell significantly.
However, over the past two months, banks’ total reserves at the Fed have declined from $3.3tn to $2.6tn as the central bank’s asset purchases slowed, usage of the swap lines declined, and the US Treasury’s cash pile increased. More cash for the Treasury means less cash for the overall banking system.
To put this $700bn reduction into context, during the period that the Fed actively reduced its asset holdings between October 2017 and September 2019, known as the Fed taper, bank reserves declined by the same amount, from $2.1tn to $1.4tn.
What happened after that? The US money market hit a liquidity pothole, with the interest rate charged on repurchase, or repo, agreements — a type of secured borrowing where cash is exchanged for collateral such as Treasuries — rising close to 10 per cent last September. The Fed was forced to inject cash to the banking system.
The $700bn reduction in bank reserves over the past two months is very different in nature, and the current level of $2.6tn is still high by historical standards. However, the past episode taught us a lesson: a seemingly high level of reserves might still be inadequate, so we should remain vigilant.
In a recent research paper written with Ricardo Correa and Gordon Liao, we took a deep dive into the daily balance sheets of large global banks and articulated why high levels of bank reserves are key to support the healthy functioning of dollar funding markets.
The first reason is that large global banks have relied on their own cash pile to provide additional lending in response to sudden surges in dollar funding demand in recent years. The alternative for banks would be to borrow additional bucks from cash-rich lenders in the economy, such as money market funds, in order to lend more to ultimate dollar borrowers. But the unpleasant consequences of this during a dollar shortage are higher external funding costs, a larger bank balance sheet and a more binding leverage ratio requirement.
Larger reserves are also important because a substantial portion of banks’ cash is set aside to comply with the regulatory requirements and risk management practices developed after the global financial crisis. Tapping banks’ own cash at the Fed to finance short-term dollar lending involves significant amounts of liquidity transfers across subsidiaries within a large bank. This is because depositary institutions hold reserves, but broker-dealers do most of the lending in the repo and FX swap markets. Therefore, any liquidity requirements at the bank subsidiary level would not only limit these internal flows but more broadly affect the dollar funding market.
This issue matters even more today, when demand fluctuations in the dollar funding markets are likely to be large. The dollar cash pile of the US Treasury at the central bank is at a record $1.8tn, compared with an average of $200bn over the past 10 years. Large fluctuations in this amount lead to swings in dollar funding conditions. An $83bn increase in the Treasury’s cash balance on September 16 last year was enough to set money markets in disarray.
In the Covid-19 fightback, the Treasury’s cash balance has become more volatile and uncertain, due to high levels of debt issuance, and uncertainty on the timing of fiscal payouts. This makes it even more vital that banks hold a lot of cash at the Fed.
The Fed can enable this by holding a large portfolio of securities, or by supplying additional funds to banks and non-banks through credit and liquidity facilities. To the extent that such facilities are meant to provide a backstop in times of stress, and as markets transition to a “new normal” of a post-virus world, the size of the Fed’s securities holdings will matter more and more for global dollar funding.
Originally posted on TechnoCodex