The dollar funding market has been referenced by several of our colleagues on this blog. A related topic is the regulatory constraints placed on financial institutions since the crisis which may be impeding the lending channel. Less attention has been paid to this topic due to the fact that dollar reserves within the domestic funding market have been plentiful as a result of three rounds of quantitative easing, which increased the amount of excess reserves in the banking system by over $2.5 trillion (at its peak). Recall in 2014, we were discussing the challenges of having too many reserves while moving away from the zero lower bound and we were questioning the Fed’s ability to control the fed funds rate against drifting too low? Recently, the circumstances have changed and the situation has been flipped on its head as the effective fed funds rate (“EFFR”) has begun trading higher, testing the upper bound of the Fed’s target range.
Some have attributed the recent cheapening of the EFFR relative to the interest on excess reserves (“IOER”) rate to quarter-end liquidity constraints and that appears to be the case. However, if this ends up not being so, the Fed may need to re-consider their monetary policy implementation strategy and communication – specifically as recent adjustments have made their messaging more muddled.
Pre-crisis, market participants used to have to keep track of only one primary interest rate: the fed funds rate. Post crisis, we shifted to a regime where three primary rates created a range: 1) the upper bound of the target range (“FFUB”) was set equal to the IOER 2) the lower bound of the target range (“FFLB”) was set equal to the Reverse Repo Rate (“RRP”) and 3) the EFFR, which sits in the middle, and has been drifting higher toward the FFUB. The FOMC just recently (on June 13) made a “technical adjustment” to address this. They increased the IOER by 20 bps instead of 25 to try and keep the EFFR closer to the middle of the bounds of the Feds’ target range (currently 1.75 – 2%). Now, following the June FOMC, the Fed’s decision to divorce the level of IOER from the FFUB and thus effectively also divorcing the FFLB from RRP (see Chart 1 below) has created five separate rates to keep straight!
Undoubtedly, the cost of dollar liquidity (borrowing US dollars over short-term horizons) has risen and will continue to rise as the Fed increases rates. However, the rise in short-term borrowing rates is impacting segments of the global economy and financial institutions differently. The Fed’s technical adjustment has led to several market narratives around the current level of dollar reserve scarcity. We believe that the current level of reserves represents sufficient supply to meet demand, however, much of the remaining reserves are currently trapped within the large domestic banks.
Our colleagues have done a great job describing the dynamics of what we view as a two-tiered dollar funding eco-system consisting of the onshore versus the offshore markets. The offshore dollar market is dominated by international banks and has been explained several times in the past. When offshore demand funding is scarce, it contributes to volatility in the cross currency basis, the widening in Libor-OIS spreads experienced earlier this year, in addition to stress in emerging markets. In this piece, we will focus on and take a more nuanced approach to understanding the domestic dollar market which is currently operating in a bifurcated fashion. On one side are the systemically important banks (referred to as domestic “GSIBs”), which are rich with reserves and deposits. On the other side, smaller banks are deposit poor. In the middle is the Federal Home Loan Bank (FHLB). Again, our colleagues have detailed the FHLB role in the fed funds market, so we will only briefly describe what is happening. The FHLB advances are meant to be a supplement to smaller regional banks. However, the FHLB has restrictions as it pertains to lending and risk management. This puts small banks in an uncomfortable position where they are limited in terms of their ability to source liquidity from the FHLB as well as larger banks. Despite having limited ways to attract liabilities to fund themselves, these small banks also are the ones’ disproportionally making loans into the local community (Chart 2).
While small banks’ (<$10B in assets) loans are growing commensurate with their equity, they are constrained to local pools of liquidity. Consider that small banks are geographically limited in terms of where they can raise deposits, can’t tap capital markets by issuing bonds or CP, are limited to FHLB advances, and under no circumstances able to get an interbank loan from a larger institution. Regulation makes it prohibitive from a cost and compliance perspective for a bank to provide an interbank loan. Therefore, these small banks are forced into the fed funds market to source incremental dollar liquidity needs (Table 1).
Pre-crisis, this would not have been a problem for small banks because liquidity was ample in the interbank lending markets. Today, participation in the fed funds market is limited. One important player in the post-crisis world has been foreign banks, which have kept the domestic intermediation process flowing. The FHLB lends to large foreign banks via the fed funds market. The foreign banks then turn around and either park as cash at the Fed earning a rate equal to IOER or lend to small banks. By leaving cash at the Fed, they earn a risk-free spread between IOER and EFFR less a small regulatory charge against the risk of the loan issued by the FHLB. This has been a unique opportunity for foreign banks who are less constrained from a regulatory perspective. In the post regulatory world, the fed funds market is a combination of few large block trades (driven by the FHLB/foreign bank arbitrage) and desperate small banks that need liquidity to lend to consumers. As the FHLB arbitrage becomes less attractive to foreign banks due to the recent drift upward in the EFFR, volumes in the fed funds market are reduced and cash moves to the next highest paying short-term equivalent (such as RRP or T-bills). Without the foreign bank spread arbitrage activity, the fed funds market starts to resemble what it did pre-crisis: the cost of the incremental dollar of funding needed by banks (specifically small banks today) to meet reserve requirements with limited alternative supply. Before moving on, we will say that this confusing and bifurcated domestic dollar funding market is the direct result of regulation reacting to the last crisis without considering the knock-on impact to small businesses and credit creation.
Some have interpreted the rise in EFFR as a sign that there are insufficient excess reserves in the system and the Fed needs to react. Some have further extrapolated that the solution will need to be ending the Fed’s balance sheet run-off policy. We disagree and believe there are in fact ample reserves which are currently trapped in the bifurcated domestic dollar funding market. This is the tale of the reserve rich versus deposit poor.
The Fed has a credibility issue if they don’t address the growing perception that they lack control of their policy rate. A tightly managed fed funds rate reduces volatility, term premium and improves investor confidences. Prior to the crisis, the Fed had nearly perfected the day to day management of volatility in the policy rate by using open market operations, however this took years of fine-tuning. The Fed will need to undergo a similar evolution today.
In the next post, we will discuss how to potentially address the drifting EFFR and more importantly how we believe the Fed can unlock the reserves hidden within plain sight in the banking system.