100 Finance & economics The EconomistDecember 21st 2019
F
romoneperspective,theFederalReserveisexpectinga quiet- Of the 17 rate-setters at America’s central bank, 13 expect
that it will not change interest rates at all during the coming year.
But monetary-policy inaction does not mean that central bankers
will enjoy a relaxing festive season. In another area for which they
are responsible, there is trouble looming. The so-called repo mar-
ket, through which financial firms lend each other more than $1trn
every day, could cause the Fed a headache on December 31st—and a
hangover in the new year.
During 2019, as the Fed partially unwound the quantitative-eas-
ing (qe) programme under which it had bought Treasury bonds to
stimulate the economy, the supply of cash reserves to the banking
system dropped (see chart). Meanwhile, a large fiscal deficit—the
result of America’s tax cuts and spending increases in recent
years—prompted more Treasury issuance. Because buying Trea-
suries means handing over money to the government, demand for
cash reserves rose. The repo market faced a supply squeeze and a
demand surge at the same time.
At first banks, of both the investment and the commercial vari-
ety, brought things into balance. According to a recent study by the
Bank for International Settlements (bis), a network of central
banks, although they had hitherto been net borrowers from the
repo market, as it tightened they became net lenders to it, easing
the strain. But in September banks too found themselves short of
cash when companies’ quarterly tax payments fell due and past
Treasury purchases had to be settled. Both factors drained cash
from the banking system and channelled it into the government’s
coffers. The repo rate, that is, the interest rate charged overnight in
the repo market, jumped above 10%.
Since then the Fed has been firefighting. At first it offered to
lend $75bn-worth of cash in repo markets overnight, every
night—an offer that was lapped up. Then it began lending for peri-
ods of up to one month and increasing its limits on overnight oper-
ations to at least $120bn. Then it sought to replace these temporary
fixes with an enduring solution. It began to increase its balance-
sheet again, thereby permanently raising the volume of cash re-
serves in the banking system. It has done this by buying $60bn-
worth of short-dated Treasuries per month. (It argues this opera-
tion is not another round of qe, which mostly involved buying
long-dated Treasuries.)
Thisweekthenewregime passed its first test. December 16th
saw a repeat of the factors that had driven the repo rate higher in
September. Payments for Treasuries and quarterly taxes were once
again due, but the day passed without drama. The repo rate rose
just 0.08 percentage points above recent levels, suggesting that the
Fed’s efforts to make the market more resilient had succeeded.
But at the end of 2019 a bigger hurdle looms. Regulators will de-
termine the penalty the biggest banks—those deemed “global sys-
temically important” institutions—must pay in the form of higher
capital requirements. The penalty varies in increments, starting at
1% of risk-adjusted assets and rising depending on five gauges of
riskiness. Among these are banks’ size and their reliance on short-
term funding, which are judged throughout the year or final quar-
ter. But the other three gauges—complexity, interconnectedness,
and global activity—are measured just once annually, on New
Year’s Eve.Dressing up for the occasion
That once-a-year measurement encourages big banks that are
close to a regulatory boundary to take temporary measures in or-
der to shrink activities, such as lending in repo markets, that can
push up their riskiness scores. These financial gymnastics matter
because big banks have an outsize effect on repo markets. Accord-
ing to the bis, the lenders most likely to scale up or down their
repo-market activity in response to changing demand are the four
biggest banks. Their apparent reluctance to lend in September was
a central reason for the spike in interest rates.
In 2018 end-of-year regulatory pressure caused the repo rate to
reach 6% on December 31st. Fearing a similar episode, which could
compound the more recent market stress, the Fed will offer to lend
almost $500bn in repo markets over New Year’s Eve. But it might
not work if banks, with an eye on their risk scores, are unwilling to
perform their usual role as middlemen between the Fed and mar-
ket participants who want cash.
The spectre of further turmoil in the repo market is uncomfort-
able for the central bank. It has been trying to calm nerves. In a
press conference on December 11th Jerome Powell, its chairman,
acknowledged the probable upward pressure on repo rates to
come, but was relatively sanguine. The Fed’s goal, he said, was “not
to eliminate all volatility”.
Yet regulators should not introduce volatility, either. It would
be relatively easy to fix the problem in future years. Measuring
banks on all five regulatory factors throughout the year would re-
move the pressure on them to try to look their best on New Year’s
Eve. And varying the capital surcharge smoothly, rather than in
steps, would eliminate regulatory arbitrage at the boundaries.
The big picture is that there is a common culprit behind the
sudden dysfunction in September and the prospect of further tur-
moil at the end of the year. Since the financial crisis, regulators
have created a world in which compliance is a major influence on
banks’ balance-sheets. That can interfere with the normal func-
tioning of money markets and bring unintended consequences.
The problem becomes most obvious at pinch points, such as
December 31st, but is true more generally. And it is making the
business of operating the financial plumbing—which was always
low-margin and balance-sheet intensive—less appealing. “Big
banks used to operate as the lender of second-to-last resort,” says
Bill Nelson of the Bank Policy Institute, an industry lobby group.
“That buffer is now gone.” Without it the Fed may need to get used
to intervening more often. 7Free exchange Christmas repeat
Despite the efforts of the Fed, the repo market will probably suffer more turbulence soonHo, no
United StatesSources:BankforInternationalSettlements;
Bloomberg;FederalReserveBankofNewYork*USbanksfilingcall reports
†Lower bound3210-1
2018 2019Daily interest rates, spread over
the Fed policy rate†
Percentage pointsEffective federal-funds rateSecured
overnight
financing
(repo)2.5
2.0
1.5
1.0
0.5
0
2007 10 1915Reserves and Treasury holdings
of banks*
$trnTreasuriesReserves