The Federal Reserve introduced the overnight reverse repurchase agreement facility (ON RRP) in 2014 to improve its control of the federal funds rate, the interest rate banks and government-sponsored enterprises (GSEs) charge each other for unsecured and mostly overnight loans. The ON RRP facility was intended to be temporary, to limit the Federal Reserve’s footprint in short-term funding markets and avoid altering the behavior of financial intermediaries in unpredictable ways. But the take-up of the ON RRP facility has surged over the past several months, and a few weeks ago, we indicated that take-up of the ON RRP could reach $1 trillion in the summer of 2021. Given the strong take-up seen over the past two months, we may have underestimated its projected growth and how persistent usage of the facility will be. In this note, we discuss some of the drivers of ON RRP take-up over the past few months, including the interaction between the Fed’s ongoing purchases of securities and banks’ balance sheet constraints.
Introduction of ON RRP
The primary tool used by the Fed to control the federal funds rate is the interest rate paid on reserve balances (the IORB rate). In theory, with reserve balances abundant, the federal funds rate should equal the IORB rate. This is because no bank would be willing to lend to another bank at a rate lower than what it could earn with its reserve balances at the Fed. If any bank needed overnight funds, there should be plenty of reserves available that banks would be willing to lend at just a touch over the IORB rate. However, in practice the IORB does not create an effective floor for the federal funds rate, because GSEs (whose unsecured transactions with banks are included in the federal funds market) are not allowed to earn interest on the deposits they have at the Federal Reserve Banks. As a result, the GSEs have an incentive to lend funds in the fed funds market at a rate below the IORB rate. Thus, the effective funds rate trades below the IORB rate. Because of the superabundant reserves environment, the federal funds rate could move below the range targeted by the FOMC (currently between 0 and 25 basis points).
To set an effective floor on the fed funds rate, the Fed created the ON RRP to allow a broader set of counterparties, including GSEs, to earn interest on their excess cash and enhance rate control. By setting the ON RRP rate equal to the lower bound of the federal funds rate target range, the Fed effectively sets a hard floor (at least, to date) for the policy rate. The set of counterparties eligible to participate in the ON RRP is quite broad and includes banks, money market funds (MMFs), GSEs and primary dealers. However, MMFs account for almost all ON RRP take-up. When the Fed introduced the facility, it acknowledged that the ON RRP could have some negative implications for financial stability, since large and sudden increases in usage could occur and amplify flight-to-safety flows during periods of financial stress. For this reason, the limit on the amount each counterparty could bid to the facility was set at $30 billion per day when the facility was introduced back in 2014. Notably, on March 17, 2021, the FOMC increased the counterparty limit to $80 billion. The FOMC argued that the increase was needed to reflect the “growth and evolution of U.S. dollar funding markets since the limit was changed in 2014.”
Surge in ON RRP Take-up After the Expiration of SLR Relief
The significant expansion in the ON RRP take-up began at the end of March 2021. In prior years, the average daily take-up was around $120 billion, with seasonal spikes at quarter-ends. On June 7, ON RRP take-up reached a record level of nearly $500 billion, and the increase since March has been steep (Exhibit 1). In the remainder of this post, we analyze some of the reasons that explain the surge in ON RRP take-up, namely regulatory drivers (the supplementary leverage ratio and the global systemically important bank capital surcharge) as well as the decline in bill issuance and the reduction in Treasury’s checking account at the Federal Reserve.
The Federal Reserve temporarily excluded reserve balances and U.S. Treasury securities from the denominator of the supplementary leverage ratio in April 2020. The exclusion followed the Fed’s massive intervention to stabilize financial markets and encouraged banks to increase low-risk, balance-sheet-intensive activities, such as making markets in Treasuries or offering repo financing to others to support trading in Treasuries. Except for early April 2020, ON RRP take-up had been essentially zero while the temporary changes to banks’ supplementary leverage ratios were in place, and the Federal Reserve’s purchases of $120 billion per month in Treasuries and agency MBS continues. The exclusions of reserve balances and Treasury securities from the SLR denominator enabled banks to increase their holdings of those assets without having to fund themselves with more capital. In contrast, since the Federal Reserve announced the expiration of the change to banks’ SLRs on March 19, 2021, ON RRP take-up increased from about zero to $486 billion on June 7, the highest value ever recorded.
As shown in Exhibit 2, deposits of large banks have remained at about $10.2 trillion since the SLR relief expired on March 31, according to the Fed’s H.8 data. During the period in which the SLR relief was effective, large banks’ holdings of deposits rose more than $2 trillion. Since the Fed has not made any adjustments to its asset purchases of $120 billion per month, the relative stability of large banks’ deposits after the end of March strongly indicates banks have started to push their nonoperational deposits to MMFs. Indeed, assets under management at MMFs increased more than $300 billion over the first half of 2021.
Bank demand for reserve balances depends significantly on the IORB rate and regulatory capital and liquidity requirements. In the superabundant reserve balances environment, the regulatory constraints that matter the most are banks’ leverage ratio requirements and the GSIB capital surcharge. Reserve balances are risk-free. However, under a leverage ratio requirement, all risk weights are set to 1. The exclusion of reserve balances and Treasuries from the SLR denominator disincentivized banks to push deposits to other banks and money funds (via the ON RRP facility). Regarding the GSIB surcharge, the Fed likely did not see the need to adjust the surcharge for the effects of its asset purchases and lending during the COVID event. This was in part because it takes about two years for a rise in a firm’s systemic score to result in an increase in capital requirements. The lag, therefore, allowed the Fed to exclude reserve balances and Treasuries from banks’ systemic scores later if this turned out to be necessary.
As can be seen by the purple bars in Exhibit 3, the changes made to the SLR denominator were instrumental in preventing the SLR from constraining banks’ ability to absorb reserve balances and purchase (and provide financing for) Treasury securities. More precisely, the yellow portion of the bars show that the temporary exclusion of reserve balances and Treasuries from the SLR raised the ratio of the largest six banks by 1 percentage point, putting the largest banks 2 percentage points above the eSLR requirement of 5 percent (red line). Exhibit 4 plots the aggregate method 2 GSIB scores of the same six banks over time. The GSIB scores of the six largest banks have risen more than 400 points since the start of the pandemic, although some of the increase in the first quarter of 2021 was seasonal. Banks will have to adjust their balance sheets, including continuing to push deposits off their balance sheets to money funds to avoid an increase in capital requirements in two years.
Moreover, and consistent with the balance sheet pressures shown in Exhibits 3 and 4, the Federal Reserve released the results of a survey of large banks’ balance sheet management policies that indicated several of the largest banks were already limiting the size of their balance sheets back in March 2021. According to the survey results, three of the eight U.S. GSIBs indicated that the eSLR was a very important reason behind their decision to reduce their bank balance sheet size, and six GSIBs said the capital surcharge was important or very important in explaining that decision.
The decrease in the Treasury General Account (TGA) balance at the Fed is another factor that explains the increase in ON RRP take-up. The TGA is a source of funding for the Fed that must be replaced with reserve balances or ON RRPs when its balance declines. As shown in Exhibit 5, TGA balances declined nearly $250 billion since the end of March 2021. In addition, the Fed has continued to purchase $120 billion in Treasury securities and agency MBS each month. The $485 billion in ON RRP take-up at the end of May was nearly equivalent to the sum of the decline in the TGA balance and the increase in the Fed’s holdings of securities since the end of March.
The increase in ON RRP take-up also likely reflects the relative “scarcity” of Treasury bills. Exhibit 5 shows a notable decline in net issuance of Treasury bills since the end of March 2021. The increased scarcity of Treasury bills puts downward pressure on short-term rates and further incentivizes MMFs to shift some of their lending to the Fed.
In summary, because of the leverage ratio and GSIB capital requirements, banks have started to push some of their clients out of deposits and into MMFs. At the same time, MMFs have a large demand for reverse repos, in part because Treasury bills are scarce (with some trading at negative yields). Furthermore, because of their capital requirements, banks are unwilling to borrow in the repo market, even at an interest rate of zero. As a result, we now have a situation where the Federal Reserve is borrowing at a zero rate from MMFs through the ON RRP facility to fund the growth of its balance sheet.
Given the current benign economic and financial conditions, the surge in ON RRP take-up does not appear to be having disruptive effects, except for increasing the Federal Reserve’s footprint in short-term funding markets. However, given the balance sheet constraints and the elevated level of the Fed’s balance sheet, it is likely that ON RRP take-up will continue to increase steadily with seasonal spikes at quarter-ends. Therefore, we could see take-up nearing $1 trillion at the end of the second quarter of 2021, driven by the seasonal spikes.
When the Fed introduced the ON RRP facility in 2014, it said maintaining a large facility size over a long period could “reshape the financial industry in ways that may be difficult to anticipate and that may prove to be undesirable.” We now have a situation in which the Federal Reserve is funding the growth of its balance sheet using the excess cash from money funds, which the Fed had to support at the outbreak of the pandemic. Banks—which were a source of strength during the crisis—are now constrained by the SLR and the GSIB surcharge because of the Fed’s monetary policy actions.
Finally, as noted in the Fed’s white paper cited above, a large and permanent ON RRP facility could also exacerbate flight-to-quality flows during a period of financial stress and undermine financial stability. For example, during times of stress, MMFs could shift their lending to the facility and away from lending to nonfinancial and financial firms. This could force those firms to get rid of assets at fire-sale prices, leading to contagion in financial markets and therefore and an increase in systemic risk. In addition, during a flight-to-quality episode, a large ON RRP can also help attract cash to MMFs that would have otherwise gone as deposits to banks.
 Furthermore, holdings of reverse repos by the largest banks have decreased by about the same amount since the start of 2021. Those serve as a proxy for increases in assets under management for MMFs.