Every day, the Federal Reserve borrows money from money market mutual funds, GSEs and certain other nonbanks at its overnight reverse repurchase agreement (ON RRP) facility. The facility is subsidizing money market funds as an attractive alternative for uninsured bank depositors. Why is the Fed continuing to operate it at its current $2.2 trillion size?
The facility was created in 2013 as a tool to ensure that the Fed could lift the effective federal funds rate above zero when it decided it was appropriate to do so. The ON RRP facility helped with liftoff by broadening the set of institutions to which the Fed was paying interest for deposits. After lying dormant for many years, the facility rose again over the past two years when the Federal Reserve could not borrow enough from banks to fund its massive balance sheet expansion through quantitative easing, and therefore needed to borrow from money funds to prevent the federal funds rate from falling below the FOMC’s target range.
Now, of course, the Federal Reserve is engaged in quantitative tightening and reducing the size of its balance sheet. Logic would suggest that the ON RRP, which was described as a temporary facility, would have been wound down as the Fed returned to using currency and reserves as its funding. To the contrary, though, the ON RRP currently sits at over $2.2 trillion.
Here, we’ll admit that we were to some extent scooped by The Economist, whose most recent issue describes the implications quite nicely in an article titled “The Missing Half-Trillion: How the Federal Reserve Drained America’s Banks of Deposits”:
Over the past year those in commercial banks have sunk by half a trillion dollars, a drop of nearly 3%. This makes the financial system more fragile, since banks must shrink to repay their deposits. Where is the money going?
The answer starts with money-market funds, low-risk investment vehicles that buy short-term government and corporate debt. These saw inflows of $121bn last week as SVB failed. However money does not actually enter such vehicles, for they are unable to take deposits. Instead, cash that leaves a bank for a money-market fund is credited to the fund’s bank account, from which it is used to purchase the commercial paper or short-term debt in which the fund invests. When the fund uses money in this way, it flows to the bank account of whichever institution sells the asset. Inflows to money-market funds should thus shuffle deposits around the banking system, rather than force them out of it.
And that is what used to happen. Yet there is one obscure way in which money-market funds may suck deposits from the banking system: the Federal Reserve’s reverse-repo facility, which was introduced in 2013. The scheme was a seemingly innocuous change to the financial system’s plumbing that may, a decade later, be having a profoundly destabilising impact on banks.
In a usual repo transaction a bank borrows from competitors or the central bank and deposits collateral in exchange. A reverse repo does the opposite. A shadow bank, such as a money-market fund, instructs its custodian bank to deposit reserves at the Fed in return for securities.
In other words, while money market mutual funds have always drawn money away from deposits at banks, that money funds economic activity and much of that money makes its way back to the banking system, either directly – as the money fund invests in repos with banks or bank CDs – or indirectly – as the fund invests in commercial paper or other corporate borrowing, which is subsequently deposited back into deposits. While money funds also invest in Treasury bills, when they pile into bills, bill yields call, reducing their attractiveness. It is only the ON RRP, with its yields that is insensitive to supply and demand, that serves as a black hole for bank deposits.
How massive a black hole? Today, 40 percent of money market mutual fund investments (44 percent for government funds) are overnight RRPs with the Fed
A Foreseeable Problem
One might have assumed that the potential for a high ON RRP rate to destabilize banks was an unexpected development that the Federal Reserve could not reasonably have anticipated. To the contrary, when the FOMC initially discussed creating the ON RRP facility, many FOMC members expressed concern that the facility would worsen financial stability and disrupt the financial system by pulling money out of the banking system and commercial paper market.
The staff presentation summarized the threat nicely, including in various places the following bullet points:
- During crises, rapid take-up at the ON RRP facility could magnify flight-to-quality
flows and contribute to a decline in the availability of short-term funding
- Cash that would have moved into liquid deposits could go into the ON RRP facility
- Availability of short-term funding could decline more quickly:
- Additional flight-to-quality flows might occur
- The financial stability implications would depend in large part on the firms that lose funding.
Indeed, then-Governors Powell and Tarullo were sufficiently concerned that they took the unusual step of circulating a memo to the Committee outlining their concerns.
The governors’ fears have proven justified. By encouraging deposit outflows from these banks into government money funds, the Fed is abetting a shift of deposits from the banking system, helping to reduce credit supply to businesses and individuals while supporting investment in the government.
A Ready Solution
This problem has a ready solution.
Currently, the Fed pays ON RRP depositors 4.80 percent, higher than more than a quarter of private repo transactions. Given that attractive rate, as noted, 40 percent of money market mutual fund investments (44 percent for government funds) are overnight RRPs with the Fed, and the Fed is borrowing $2.2 trillion through the facility, nearly a quarter of all Fed liabilities including currency.
The ON RRP interest rate is attractive compared with other money market rates because it is currently only 10 basis points below the interest rate the Fed pays on reserve balances to banks (the IORB rate). For most of its history, the ON RRP rate was 25 below the IORB rate, and use of the facility was essentially zero. That higher spread lifts other money market rates up further above the ON RRP rate. To reverse the giant sucking of the ON RRP, all the Fed need do is lower the interest rate it pays on the ON RRP relative to the rate it pays on reserve balances, for instance by returning the spread between the two to 25 basis points.
In sum, the Fed’s fears for the ON RRP have been realized, and the ON RRP is causing significant damage at a time when it has lost its purpose. Shouldn’t that be a reason to change policy?