The flair up in the repo market back in September caught a lot of people off guard—including the Federal Reserve. The issue area is arcane and complex, and I’m not the best expert, but I think I understand it enough to try and lay out what happened and why.
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Since there’s a non-zero chance this issue flairs up again around year-end, it’s important to have the understanding of the underlying issues—if for no other reason than to see more quickly thru the bullshit.
There are two main types of change post-GFC that led the desired amount of excess reserves to be much higher than anyone had anticipated.
One, volatility in reserves increased dramatically, for two reasons:
- For various reasons related to the GFC, the Fed took actions that allowed the Treasury to keep its all of its money at the Fed, whereas before the Treasury kept almost all of its money outside of the Fed Funds system, in banks. And since one dollar of Fed funds in the Treasury account reduces reserves available to others by one dollar, this, as the Treasury built up and drew down on its account, led to much greater volatility in the excess reserves available to banks.
- The Fed during the crisis removed the cap to and restrictions on foreign banks participating in the repo market. Oscillations in their demand for repo operations also added volatility to the amount of available reserves.
If the volatility in available reserves is higher, it becomes optimal for banks to keep a larger cushion of them.
The second type of structural change was behavioral: the preference for reserves over Treasuries (as an HQLA) shifted significantly.
- Reserves settle t+0, while Treasuries settle t+1. You can always meet a large unexpected demand for settlement with reserves, but not always with Treasuries.
- Reserves now pay interest, and do so at a rate of interest roughly equal to T-Bills, so there is no monetary opportunity cost to holding reserves instead of Treasuries.
- The stigma of having to go to the discount window increased sharply post-GFC. (If you get caught short of reserves and need to make same day payment, the discount window is your only option.)
- PTSD and the conveyed expectations of the bank supervisors leads strongly to erring on the side of caution.
- Capital charge on lending in repo is the same as for unsecured bank lending under bank leverage rules, which further inhibited the cautious banks from trying to take advantage when the repo rate spiked from 2 to 10 percent.
This was the reserve backdrop going into September. And then the repo market got hit with a two-sided shock.
On one side, the Treasury issued an unusually large slug of bonds, which primary dealers had to finance in the repo market. This increased the demand to borrow thru repo.
On the other side, corporations around the same date had to make large estimated tax payments, the funds for which they needed to withdrawal from the overnight market, a market which lends heavily via repos. So, we ended up with a positive demand shock and a negative supply shock. And this happened against a backdrop of cautious banks with a strong preference for reserves over treasuries.
The bottom line is there are plenty of excess reserves in the system for settlement purposes, but the banks have been extremely reluctant to part with them for the structural and behavioral reasons given above. This creates a sense of hoarding. The Fed now understands this and they are working with the banks to figure out ways to reduce the volatility in available reserves and loosen some of the de facto and de jure factors leading to reserve hoarding.