On Feb. 17, BPI hosted its fourth roughly annual informal symposium on monetary policy, bank regulations, and money markets. The symposium was attended by current and senior policymakers from multiple government agencies and central banks; academic experts on monetary policy and financial markets; and market participants including bank treasurers, front-end rate strategists from buy-side and sell-side firms, and chief economists. As described in the agenda available here, the symposium covered four topics: the outlook for deposit rates and deposit levels, the prospects for the Fed’s new Standing Repo Facility (SRF), how the Fed’s balance sheet and money market rates will evolve as the Fed tightens policy, and Treasury market functioning as the Fed’s switches from purchases to redemptions. The symposium was designed to be a discussion rather than a traditional panel followed by questions and answers, although designated speakers started off each discussion. This note summarizes the discussion and ends with some thoughts on the broader implications.
Deposits
The discussion covered how deposit rates paid by banks and the level of deposits are likely to respond as the Fed pushes up money market rates. Deposit-rate sensitivity to money market rates is often discussed in terms of the deposit “beta.” The deposit beta is the proportion by which deposit rates go up or down in response to a corresponding movement in money market rates, often the federal funds rate. Over the past several decades, the deposit beta has been relatively stable at 40 percent. That is, when the federal funds rate falls 1 percent, deposit rates fall 40 basis points, and when the federal funds rate rises 1 percent, deposit rates rise 40 basis points. The low responsiveness of deposit rates to market rates may be because customer-bank deposit relationships tend to be sticky. Deposit rates are also typically below money market interest rates, at least in part because a customer deposit account is not just a short-term investment, it also includes payment services and other functionality the cost of which is reflected in the spread between market rates and deposit rates.
Participants discussed several reasons why the deposit beta may be different relative to previous cycles as the FOMC raises the federal funds rate over coming quarters. Mechanically, deposit and money market interest rates are all currently scrunched up at zero, so deposit rates may respond less than normal as the funds rate rises from zero and a spread between the rates opens up, resulting in a low initial deposit beta. Such a relationship was also observed at the start of the most recent policy tightening five years ago. As a result, the relationship between deposit rates and the fed funds rate could be nonlinear, with the beta increasing as the funds rate rises. Moreover, the now-ubiquitous use of banking apps and auto-pay may have increased the stickiness of the deposit relationship, reducing deposit rate sensitivity. On the other hand, the rise of internet banking and nonbanks has potentially increased competition for deposits. Similarly, some banks have made it easier to switch between deposits and money market funds, which may also have increased the sensitivity of deposits to market rates.
Inseparably combined with the issue of how deposit rates will respond to a rise in the federal funds rate is the issue of how deposit levels will respond. Over the past two years, with deposit rates and money market rates essentially equal at zero and a very large fiscal stimulus, customers have increased their deposits by hundreds of billions of dollars. As market rates rise and the opportunity cost of maintaining those deposits increases, many customers will transfer funds into money funds or, in the case of corporate customers, direct holdings of money market instruments. The more banks wish to hold on to those deposits, the more deposit rates will rise with market rates. Some banks have invested the massive inflow of deposits primarily in short-term, liquid, low-yielding instruments and would likely not resist outflows. Other banks have used the deposits to fund longer-term investments and so may compete more aggressively. The choice of investment presumably reflects banks’ expectations of the deposit beta of their customers. The value of the deposits will also depend importantly on the growth of loans. Loan-to-deposit ratios are currently very low, indicating that banks do not need all their deposits to fund their loan book, but loan growth may pick up as the expansion continues.
Participants also discussed the issue of where the deposits would go. The total amount of deposits can, of course, rise or fall as bank customers’ demand for deposits and bank preferences about supplying deposits change, but the level of deposits is nevertheless determined in a system that can be thought of as closed.[1] If a customer shifts funds from a deposit to a money market mutual fund, another deposit could be created (for instance if the money fund purchased a nonbank liability or a Treasury security in the secondary market), or the total amount of deposits could fall (for instance if the money fund bought bank CP or a Treasury security on the primary market). One important possibility, discussed further below, is that the money fund could lend the money to the Fed at the Overnight Reverse Repurchase Agreement (ON RRP) Facility, in which case the level of customer deposits at banks and bank deposits at the Fed (reserve balances) would both fall.
Standing Repo Facility
In July 2021, the Federal Reserve opened a new lending facility, the Standing Repo Facility (SRF). Under the SRF, each afternoon, the New York Fed auctions at a fixed interest rate a large quantity of repo funding against Treasury securities, agency debt and agency MBS (Open Market Operations or “OMO” securities). The Fed initially opened the SRF only to primary dealers – the large broker-dealer counterparties of the Fed in open market operation – and has since expanded eligibility to include large banks. To participate, the institution must be able to settle transactions on the triparty repo platform, which is used almost exclusively by large financial institutions. The interest rate has been set at 25 basis points, well above market rates, and borrowing has been zero to date. Because the credit is extended under the Fed’s open market authority (Section 14 of the Federal Reserve Act) rather than the Fed’s discount window authority (Section 10B), and because the collateral is limited to OMO securities, the Fed hopes that the facility will be free of stigma unlike the regular discount window, which banks are extraordinarily reluctant to use.[2] By creating a lending facility that broker-dealers and banks are willing to use, the Fed hopes to prevent any temporary pressures in the repo market from spilling over to the federal funds market, reduce the likelihood of disorderly selling of OMO securities owing to a lack of funding, and possibly increase bank willingness to hold OMO securities as a source of liquidity rather than reserve balances to facilitate the coming reduction in the size of the Fed’s balance sheet.[3]
Participants were broadly skeptical that the SRF would be successful. While all primary dealers have access to SRF, to date, only three banking institutions, in each case an affiliate of a large broker-dealer, have signed up to use the facility. Banks and primary dealers are concerned that borrowing from the Federal Reserve will be held against them by their examiners and by the public.
A participant noted that regional banks were initially intrigued by the SRF because it could provide a way to liquidate holdings of OMO securities without selling them into possibly illiquid markets, but interest waned for five reasons:
- The high minimum bid rate and expense of getting access to the triparty repo platform made it cost-prohibitive.
- The overnight term of the loans was poorly aligned with regional banks’ contingency funding needs.
- It was unclear how use of the facility would be viewed from a supervisory standpoint including whether if it would be possible to include use of the facility in liquidity stress testing.
- It was unclear how use of the facility would be viewed in the market, with preliminary discussions suggesting it would be viewed like using the discount window (that is, negatively).
- Use of the facility would be operationally complex for a regional bank. It would require the bank to establish a tri-party repo arrangement, work with a new securities custodian, and ensure that cash from any borrowing ended up at the Fed, not the custodian, so that the borrower’s risk-based capital requirements did not increase.
Participants agreed that the most promising way the Fed could increase the likelihood that broker-dealers and banks were willing to use the SRF was to encourage use of it as a normal-course-of-business source of liquidity. Doing so would require reducing the facility interest rate so that it was used regularly, not just in emergencies.
Impact of Monetary Policy Tightening on Money Market Conditions
The FOMC is currently providing an extraordinarily high amount of monetary policy stimulus in two ways. First, it has set its target range for the federal funds rate at the very low level of 0 to 25 basis points, a level it implements by setting the IORB rate (the interest rate it pays on reserve balances) at 15 basis points and the ON RRP rate (the interest rate it pays on reverse repurchase agreements) at 5 basis points. Second, it is pushing down longer-term interest rates by owning $8½ trillion in Treasuries and agency MBS. The Fed is funding its securities portfolio by borrowing from the public ($2.2 trillion in currency), borrowing from banks ($3.8 trillion in reserve balances), borrowing from money market mutual funds ($1.7 trillion in ON RRPs), and borrowing from Treasury ($0.7 trillion at the Treasury General Account (TGA)). With inflation elevated and employment full, the Fed has signaled that it will begin to reduce stimulus by starting to raise its target range for the federal funds rate at its next regular meeting in March, and by allowing its holdings of securities to run off as they mature starting later this year.
The focus of the session was on how, precisely, the Fed’s (and therefore financial institutions’) balance sheet was likely to evolve, and how different money market interest rates were likely to change, as the Fed tightened policy. The initial phase of the Fed’s balance sheet expansion beginning in March 2020 was funded through an increase in reserve balances. However, in March 2021, a crisis-related exemption of reserve balances from the supplementary leverage ratio requirement ended, raising the amount of capital that banks must use to finance their reserve balances, making such holdings more expensive. At that point, use of the ON RRP facility grew from near zero to its current high level as money funds became the marginal lender to the Fed. However, the growth in the ON RRP facility was not just caused by liquidity spilling over from unwanted bank reserves, it was also pulled in by increased investments in money market funds and a shortage of government securities in which the funds could invest. The Fed balance sheet unwind will be complicated by the fact that Fed RRPs have become a core asset class for the money markets; this has become the latest twist on the scarcity-of-safe-assets story of recent years.
While it might, therefore, seem likely that the ON RRP facility would decline first as the Fed reduced its portfolio of securities, participants generally judged that to be unlikely. Instead, the flow of deposits out of banks and into money funds when the Fed raised interest rates discussed above was seen as resulting in a possibly significant initial rise in the ON RRP facility and corresponding decline in reserve balances.
The details of when and how the Fed could reduce its securities holdings remain to be seen. The Fed could begin allowing maturing securities to roll off without reinvestment as early as May. If the Fed allowed its bills to mature without replacement, and set the caps on redemptions relatively high, its portfolio could decline at almost $1 trillion a year, although several participants judged that possibility to be an upper bound. There was no consensus on the prospect for the Fed to sell MBS, with some seeing sales as something that could be used from the outset to smooth the rate of decline in the portfolio, while others saw it as a possibility only later in the process to hasten the return to a portfolio of mostly Treasury securities. Participants judged that the Fed would ultimately decline in size to about $6 to $6.5 trillion from its current level of nearly $9 trillion.
One participant described money market conditions as likely to evolve through three phases as the Fed reduces its balance sheet. During the initial phase, reserve balances would be abundant and bank deposits would shift into money funds. During that period SOFR (the “secured overnight financing rate,” a measure of average Treasury repo rates) would remain relatively low, near the ON RRP rate and above the fed funds rate, which would be below the IORB rate. During the second phase, reserves would remain ample, but banks would compete more aggressively for deposits and ON RRP use would decline. SOFR would move closer to the fed funds rate and both would rise toward the IORB rate. During the final phase, some signs of scarcity in reserve balances would emerge. SOFR would exceed the fed funds rate and both would be above the IORB rate.
Treasury Market Functioning and Balance Sheet Normalization
During the “dash for cash” at the outset of the COVID-19 pandemic, the Federal Reserve intervened massively in the Treasury market to support market functioning. As described in a recent New York Fed staff study, the purchases totaled over $2 trillion between the middle of March and the end of April.[4] To date, since the beginning of February 2020, the Fed has purchased $3.3 trillion in Treasury securities.
Underlying the need for such massive intervention has been a steady decline in the capacity of the Treasury market to handle episodes of heightened flows. The amount of Treasury debt has grown to five times its level in 2007 while over the same 15-year period the amount of primary dealer balance sheet committed to supporting intermediation in Treasury markets has been essentially unchanged. As a result, the market is increasingly unable to handle the level of flows during periods of stress. The resulting Federal Reserve interventions could engender moral hazard, with market participants taking excess risk on the expectation of further such interventions.[5]
Participants discussed the recommended steps to improve Treasury market functioning in two recent major studies: “U.S. Treasury Markets, Steps Toward Increased Resilience,” by the G30 (available here), and “Report of the Task Force on Financial Stability,” by the Brookings Institution and the Booth Business School, available here.
- The SRF as well as a similar facility created for foreign official institutions was seen as possibly helping reduce the likelihood of disorderly selling of Treasury securities by enabling institutions to convert their securities into cash. On the other hand, it was noted that the SRF likely did not help increase Treasury market capacity significantly because it was only available to primary dealers and large commercial banks and just three commercial banks, all of which are affiliated with primary dealers, have thus far expressed interest in becoming SRF counterparties.
- The primary dealers predominantly are large, bank-affiliated dealers. Their capacity to intermediate in the Treasury markets is being constrained by the SLR, because the SLR requires banks to hold capital on low-risk Treasury securities and even lower-risk reverse Treasury repos, and because the growth of reserve balances has resulted in the SLR being the binding capital constraint for about half of large banks weighted by assets, it is holding down Treasury market intermediation.[6] Although the Fed said that it would soon advance proposals to fix the SLR when it allowed the temporary exclusion of reserve balances to end in March 2021, it has not done so.[7]
- Increased central clearing of Treasury repo transactions, and greater use of all-to-all trading in which the dealer is not a counterparty, could reduce the amount of dealer balance sheet necessary for intermediation.
- Participants disagreed about the advantages of greater transparency about Treasury market transactions. Such transparency might enable more entities to provide liquidity because they would have better information on where the market is trading, but it also could allow for the front-running of large trades in relatively illiquid issues.
Participants also discussed how Treasury market functioning would hold up as the Fed ceased its purchases and began to let its holdings run off. Participants judged that market function should remain fine unless there were any periods of stress caused, for example, by events such as a war in Europe or a sharp increase in longer-term rates if the path for monetary tightening is revised up. If there were any such disruptions, the Fed could have to stop reducing its portfolio and instead recommence purchases. Several participants noted that it would be helpful if there were a way to distinguish between Treasury purchases to support market functioning and Treasury purchases to stimulate the economy by reducing longer-term interest rates. One way to achieve such a division would be for the Treasury to take responsibility for one task or the other, either by using repurchases to address financial turmoil, leaving interest rate management to the Fed, or adjusting the maturity of its borrowing to push down longer-term rates when needed, with the Fed addressing market turmoil.
Conclusion
At the end of the symposium, many of the participants stayed online to continue the discussion. One topic that was discussed was whether the issues that were covered mattered for macroeconomic outcomes. The meeting largely covered financial market plumbing. That outcome was, of course, by design, because plumbing issues can be key determinants of spreads that may open up between different money market interest rates, or deposit flows relevant for banks’ asset-liability management. As such, they matter a lot for the plumbers who attended the meeting. But the broader economy is influenced by the general level of interest rates determined by the Fed’s actions, and nothing discussed seemed likely to prevent the Fed from broadly achieving its interest rate objective.
Nevertheless, many of the issues discussed could present significant stumbling blocks for the Fed as it tightens. For example, regardless of their level, a sharp drop in reserve balances caused by a rise in the ON RRP facility could disrupt money markets and cause an unwanted rise in the federal funds rate. To prevent such an outcome, the Fed may want to allow a wider spread to open up between the IORB rate and the ON RRP rate as it tightens policy. If the SRF does not work as intended, the Fed may meet resistance shrinking its portfolio of securities as scarcity in the market for reserves materializes sooner than expected (as happened in 2018), requiring the Fed to stop redemptions and instead raise the federal funds rate more aggressively. And a disruption in Treasury markets could require a difficult-to-explain reversal of quantitative tightening or worse, spark broader financial instability.
[1] For further explanation see the BPI blog post “QE May Raise Deposits Temporarily, but Not Permanently.” https://bpi.com/qe-may-raise-deposits-at-banks-immediately-but-not-permanently/
[2] See BPI blogs “Discount Window Stigma: We Have Met the Enemy, and He Is Us,” “A Major Limit on the Fed’s Crisis Toolkit: Shame,” and “More Taxis Sitting Idle.”
[3] See New York Fed blog “The Fed’s Latest Tool: A Standing Repo Facility,” and BPI blog “Design Challenges for a Standing Repo Facility.”
[4] “The Federal Reserve’s Market Functioning Purchases,” available here.
[5] See the BPI blog “Federal Reserve Support for Market Functioning,” available here.
[6] See BPI blog “Fix Bank Leverage Requirements Now, in Advance of Upcoming Treasury Market Stress,” available here.
[7] See “Federal Reserve Board announces that the temporary change to its supplementary leverage ratio (SLR) for bank holding companies will expire as scheduled on March 31,” available here.
