How the Fed aims to prevent the next financial crisis using the Standing Repo Facility
At first, I called this post "More on Quarles and the introduction of a standing repo facility". But that's not a sexy title is it? That's because repo isn't a sexy topic. I think it's important though. If we have a liquidity crisis though, everyone will be talking about it - because that's where the financial meltdown would occur.
And because repo rates spiked dramatically in September, there's already a decent amount of buzz in financial circles about it. But repo is very much in the weeds. And so, it's not 'sexy' like talking about a possible recession due to the coronavirus or a Tesla bubble popping.
I'm going to give it a go anyway. And I'm going to put it outside the paywall too! Consider this a follow-on to the section in yesterday's post that talked about Federal Reserve Governor Randal Quarles' speech on the Fed's balance sheet. But, rest assured I'll make this as brief as possible.
The Balance Sheet Size Issue
I noted that the Quarles speech showed discomfort at the Fed both with the size of the Fed's balance sheet and the concept that quantitative easing "permanently" adds to the Fed's balance sheet. I focused on this section of his speech:
I believe that the viability of balance sheet policies is enhanced if we can show that we can meaningfully shrink the size of the balance sheet relative to gross domestic product following a recession-induced balance sheet expansion. In effect, I believe that balance sheet policies are more credible if we can show that there is not a persistent ratcheting-up effect in the size of the Fed's asset holdings.
Why is quantitative easing more 'credible' if the balance sheet impact isn't 'permanent'. Quarles doesn't say. My guess is it follows from where he says "Balance sheet policies can put further downward pressure on longer-term yields by reinforcing the credibility of the forward guidance". But that's just a guess.
It would be a lot more credible if the Fed just said it was willing to buy unlimited quantities of a particular Treasury rate maturity range at a specific price, just as it does in the Fed Funds market. Then, it wouldn't even have to buy Treasury securities. The mere threat of intervention - by the monopoly supplier of reserves who can simply create reserves on demand to buy Treasuries - would cause market rates to adjust without actual intervention. The Fed's balance sheet wouldn't go up at all.
And we wouldn't be talking about this then. But the Fed is committed to using its balance sheet as an 'unconventional' tool of monetary policy. So we have to talk about it.
Shrinking the balance sheet and making Treasuries cash
So, to sum up, the goal here, then, is to be able to shrink the Fed's balance sheet without it causing any problems in the economy or the financial system. That's what the Fed was trying to do when it started up quantitative tightening.
But that policy ran into a brick wall when repo rates spiked in September. If you want a refresher on the issues that were at stake, here's a Bloomberg article from September that's pretty good on what was happening. It got so bad that some people started warning of a financial crisis. And the fears of another repo market crisis at year end caused the Fed to flood the market with liquidity, over $400 billion of it.
The Fed says this was just about the repo situation. But, a lot of people are acting like this was effectively another round of quantitative easing - a signal that the Fed was going to remain accommodative. And so, people bought lots of financial assets and asset prices soared.
Thus, the complication for the Fed here is that - while all government liabilities are fungible from the government's perspective, since they are all simply IOU promises to pay in the future, and the government can simply create more IOUs whenever it wants - we don't consider all government liabilities the same. In the banking system, 'money' and Treasury securities are not treated equally. Here's Quarles saying that in Fedspeak:
Treasury securities' liquidity characteristics were regarded as more similar than they are today—that is to say, that reserves and Treasury securities were more easily substitutable in the context of liquidity buffers.
Translation: wouldn't it be nice if banks treated Treasuries and reserves as basically the same thing when they want to hold cash on their balance sheets as a buffer against a liquidity crisis? The repo mess in September tells us they don't. If they were totally fungible, we wouldn't have needed to buy up so many Treasuries and flood the market with reserves last year.
So, Quarles is thinking of ways to make Treasuries more 'money'-like, more fungible with bank reserves.
There have been a number of good write-ups on this over the past year. Take a look at FT Alphaville's Claire Jones on this topic here.
The Standing Repo Facility
But I think Quarles is channelling David Andolfatto and Jane Ihrig of the St. Louis Fed. They wrote this up in March and April of last year, recommending the Fed institute a standing repo facility before we even had a repo problem.
Here's the key bit from March:
The Fed could easily incentivize banks to reduce their demand for reserves by operating a standing overnight repurchase (repo) facility that would permit banks to convert Treasuries to reserves on demand at an administered rate. This administered rate could be set a bit above market rates—perhaps several basis points above the top of the federal funds target range—so that the facility is not used every day, but only periodically when a bank needs liquidity or when market repo rates are elevated.
With this facility in place, banks should feel comfortable holding Treasuries to help accommodate stress scenarios instead of reserves. The demand for reserves would decline substantially as a result. Ample reserves—and therefore the size of the Fed’s balance sheet—could in fact be much closer to their historical levels.
Now, let's remember why this matters - because Andolfatto and Ihrig tells us why
In April, they went on to add a section titled "Minimally Ample Reserves". I am going to bold the paragraph right at the beginning:
Why the desire to minimize the demand for reserves? In short, because it accords with the FOMC’s stated preference to operate a floor system with the minimum level of reserves necessary to permit the efficient and effective conduct of monetary policy: “minimally ample reserves” for short.1 This view was reiterated by Federal Reserve Chairman Jerome Powell on March 8:2
The Committee has long said that the size of the balance sheet will be considered normalized when the balance sheet is once again at the smallest level consistent with conducting monetary policy efficiently and effectively. Just how large that will be is uncertain, because we do not yet have a clear sense of the normal level of demand for our liabilities.
The stated uncertainty over what constitutes “minimally ample” is significant. Present estimates—based in part on survey questions posed to bankers—place the number north of $1 trillion. (Reserves are currently at $1.6 trillion.)
Reported demand, however, takes as given the present institutional setting. We think there is reason to believe that reported reserve demand could fall to much lower levels if respondents knew they had access to a standing repo facility that worked differently than the discount window presently in place.
So, the Fed wants minimally ample reserves and the standing repo facility is the way to get there. Note, that Andolfatto and Ihrig go on to add how they see this playing out:
As we mentioned in our earlier post, a study by the Federal Reserve Bank of New York suggests that eight large banks may want to hold close to $800 billion in precautionary reserves to cover their immediate liquidity needs in times of stress. The desire to hold this level of precautionary balances for resolution purposes would be significantly curtailed if the Fed made available a standing repo facility that offered a lower lending rate and stood ready to accept U.S. Treasury securities at little or no discount.
I think this is where we're headed. And that's what Quarles was telling you.
The important bit here that I left out is that the Fed believes the standing repo facility is necessary because the discount window doesn't get the job done. There is a stigma attached to borrowing from it because funds there are more expensive than in the private market, making borrowing there seem like the last resort of a troubled financial institution . See the Fed's 2017 piece: Stigma and the discount window. So, the standing repo facility can come into being and start up without that stigma.
Moreover, as Andolfatto and Ihrig write in the March piece, "the facility should be thought of as a complement to the existing overnight reverse repo facility... Together, these two facilities would create the standard deposit and lending tools used in typical floor-operating regimes, such as at the European Central Bank." That means the standing repo facility has other purposes beyond just making Treasuries and bank reserves fungible.
The sense I get is that the Fed is both uncomfortable with the size of their balance sheet and with the ad-hoc nature of their response to the recent repo crisis. The standing repo facility is now seen as the tool to fix both those problems.
And, I also think the Fed realizes that regulators have been pushing for dependence on collateralized overnight lending markets like the repo market. And any future liquidity crisis is going to be centered there as a result. The right thing to do is make sure that market is bulletproof sooner rather than later. That could prevent the next liquidity crisis from becoming the next global financial crisis.