Over the past couple of months, the Clearing House has highlighted the dramatic movements in financial market flows and prices that occur each quarter-end, in large part because the leverage ratios of European banks are calculated on a quarter-end basis. In October, we described the end-of-quarter swings in U.S. money markets, when hundreds of billions of dollars in money fund investments shift for a few days from European banks to the Fed’s overnight reverse-repurchase facility. In December, we described how foreign exchange markets are similarly buffeted, with large, but temporary, apparent violations in non-arbitrage conditions that should hold between dollars and yen. In this note we report that these pressures continued unabated over the recent year-end.
Quick background: a leverage ratio is a measure of a bank’s capitalization that is calculated as the ratio of equity to assets with no risk-weighting of the assets. As part of the Basel post-crisis international regulations, all internationally active banks are subject to the supplementary leverage ratio (SLR). The Basel standard is a SLR of 3 percent, but the United States bank regulators adopted an “enhanced” supplementary leverage ratio (eSLR) of 6 percent for the largest commercial banks and 5 percent for their bank holding companies. Most importantly, for the present analysis, note that the SLR in the United States is measured as an average of daily values while, in Europe, the SLR is measured only at quarter end.
With respect to U.S. domestic money markets, at quarter ends, use of the Fed’s overnight reverse repurchase (ONRRP) facility increases sharply because European banks temporarily reduce their borrowing from money market mutual funds and GSEs, which then instead invest in the Fed’s reverse repurchase facility. In addition, repo rates spike up as borrowers scramble for lenders and the fed funds rate falls as branches of FBOs stop borrowing in the unsecured interbank market. These patterns were again seen over year end, use of the ONRRP facility rose about $150 billion, consistent with spikes over recent quarters and years. The GCF repo rate jumped 50 basis points. And the fed funds rate dropped 9 basis points.
In foreign exchange markets, the impact exceeded past levels. One of the few “laws” of economics, covered interest parity or “CIP”, is that it should cost the same to borrow funds in dollars as it does to borrow in another currency, buy dollars, and buy the foreign currency needed for repayment of the loan in the futures market. In recent years, Japanese financial institutions have invested heavily in dollars, funded with yen deposits, and European banks have taken the other side of that position. At each quarter end, the European banks pull bank and it becomes temporarily very expensive to borrow in dollars relative to yen, violating CIP. Our December note points out that the spikes are exactly what one would expect to see if the European banks have to temporarily take into account the cost of equity associated with the trade. Over the recent turn, however, the violation was several times as large, suggesting that the price dislocation may have been magnified by illiquid market conditions.
As discussed in a recent Wall Street Journal article, the impact on European financial markets was even more dramatic. For example, the euro overnight repo rate against German government bonds fell to -4.4 percent on December 29 from -0.7 percent the week before. And the violation of CIP between euro and dollars was even more pronounced than the violation between yen and dollars.
As we noted in our previous blogs, the natural experiment that occurs when the leverage ratio requirement in Europe is switched on and then off again at quarter ends provides compelling evidence that the leverage requirement, rather than acting as a backstop to risk-based capital requirements, is having a material impact on financial market conditions. That impact was, if anything, intensified at the end of 2018. Meanwhile, every day of the quarter, U.S. broker dealers are subject to a leverage requirement that is twice the international standard, impairing their competitiveness and providing them a perverse incentive to shift toward higher-risk activities where the playing field is more level.
Disclaimer: The views expressed in this post are those of the author(s) and do not necessarily reflect the position of The Clearing House or its membership, and are not intended to be, and should not be construed as, legal advice of any kind.