Since overnight lending rates in the U.S. spiked as high as 10% during trading on 17 September, steps taken by the New York Federal Reserve and the Federal Open Market Committee (FOMC) to inject excess cash into the financial system have succeeded in calming funding markets. However, the episode is a stark reminder of an unintended consequence of post-crisis regulations.
Large banks in the U.S. now operate with greater levels of capital and liquidity, which makes the system sounder, but regulations have also reduced the efficient flow of cash through the financial system and constrained the Fed’s ability to further normalize the size of its balance sheet.
While this may not matter most of the time, these frictions can create periods of elevated funding levels and episodes of stress in liquidity markets around scheduled settlement dates for U.S. Treasury issuance and important regulatory filing dates. But more importantly, a still-large balance sheet could make FOMC members warier about expanding the balance sheet during a future downturn. Instead, members might favor policies that extend the weighted average maturity of assets held, or rely more heavily on forward guidance to control the yield curve.
Still, we think there are policy tools in the Fed arsenal that wouldn’t materially alter the soundness of the banking system but could allow cash to move more freely, potentially contributing to fewer dislocations and lower systemwide liquidity needs.
Funding market stress revealed banks’ need for liquidity
Over the past several years, the U.S. Federal Reserve has been slowly normalizing the size of its balance sheet, including reducing banks’ excess reserves, as U.S. economic fundamentals improved. Until recently, that process had occurred with relatively little disruption. However, in mid-September short-term lending rates unexpectedly ratcheted higher as banks struggled to maintain adequate liquidity in the face of large corporate tax payments and other factors, which abruptly drained $100 billion–$150 billion in cash from the banking system.
In response, the Fed injected $75 billion through its temporary overnight open market operations (OMO) and subsequently announced a program to buy U.S. Treasury bills, which will inject $60 billion per month through March of 2020. Overall, we estimate these operations will increase banks’ aggregate cash reserves by roughly $300 billion–$1.5 trillion and lift the Fed’s total balance sheet to $4 trillion.
These cash infusions have succeeded in calming short-term funding markets. However, there is no guarantee the extra liquidity will always be efficiently allocated around the banking system. As a result, we expect funding market pressures to reemerge as we approach important bank reporting dates, including year-end.
Why aren’t reserves allocated efficiently?
Although the eight largest U.S. banks hold more than $1 trillion in excess reserves (see Figure 1), a variety of regulations and supervisory expectations limit their ability to invest them into short-term funding markets, which help efficiently allocate funds across the system.
For example, to comply with the Comprehensive Liquidity Analysis and Review (CLAR) and resolution and recovery stress-testing requirements, banks are expected to hold adequate cash liquidity to meet funding needs during stressed market conditions. Although the exact level of cash required varies by bank and is not disclosed publicly, we estimate that the largest banks needed roughly all of their reserves to comply with these regulations, constraining their ability to lend cash in funding markets during the September episode.
We expect other bank regulations to further constrain banks’ willingness to lend over year-end. The largest banks are subject to a global systemically important bank (G-SIB) capital surcharge that is based on the size and complexity of their balance sheets on the last day of the year. In recent years banks have actively reduced short-term lending over the year-end period to minimize this surcharge, and we expect this year to be no different.
Regulatory policy conflicts with monetary policy
More importantly, the recent episode reminds us that a sounder financial system has not come without some costs. Post-crisis liquidity regulations have increased banks’ need for highly liquid assets, including cash, which has constrained the Fed’s ability to fully normalize its balance sheet – and could complicate its ability to employ extraordinary measures in a future downturn.
Alternatively, the Fed could take steps to address these unintended consequences in ways that would not materially alter the soundness of banks. We believe excess reserves could be more efficiently allocated around the financial system if regulators allowed the largest banks to count U.S. Treasury bills toward their intraday liquidity requirements. Separately, the Fed could potentially launch an unlimited standing repo facility that could serve as a further source of liquidity in the event that unexpected market stress pushes funding rates significantly above the upper bound of the fed funds rate.
Taken together, these changes, which are currently under discussion, could enable the Fed to maintain lower reserves while also giving banks flexibility to provide funding during periods of market stress – a potential win for monetary and regulatory policy.
Jerome Schneider is a managing director and PIMCO’s head of short-term portfolio management, Tiffany Wilding is a PIMCO economist focusing on the U.S., and Del Anderson is a PIMCO corporate credit analyst. All are contributors to the PIMCO Blog.