Saturday, September 21, 2019

The Absurd Fear Mongering Begins: "One or more big financial companies have run out of cash to pay bills they owe."

Federal Reserve Bank
Update below.

By Robert Wenzel

A very technical thing is going on in the very technical overnight financial markets.

In response to the activity, I am seeing comments like these:
One or more big financial companies have run out of cash to pay bills they owe.
The FED is bailing out some players who have played it so close in chasing higher interest income that some loans have gone bad or payments have been delayed, and now they’re scrambling to get the cash to pay their own obligations.
Sooner or later, we’ll find out which institutions were troubled (insolvent).
None of the above are true. 

Here is what is really going on.

The overnight market is where the big boys play.

At the start of the week, overnight rates started to soar.

I ran this chart in the EPJ Daily Alert.

This chart shows the change in the (overnight) Fed Funds rate over the last 10 years. That spike right at the end is what happened this past week.

As I have previously noted, the rates on overnight general collateral repos over the last couple of days have exploded to as high as 10%. This is a serious spike given that the target Fed funds rate was 2.0% to 2.25% at the time.

Why did this occur?

It was probably a confluence of factors. Two key factors were likely that the Treasury was in the market selling securities at the same time corporations were making their quarterly tax payments.

When the Treasury sells securities and raises new cash (as opposed to just rolling over securities), the money it receives is taken out of the active central Federal reserve system and placed in a special Treasury account at the Federal Reserve. So if an investor bought $1 million of these securities and paid with a check on XYZ bank, the bank would have to supply a million dollars to the Fed to put into the special Treasury account. 

If the bank didn't have the extra reserve funds to pay the Fed, it would go into the Fed funds market to borrow the funds. This is done every day.

At the same time, corporate tax payments were being made, which is corporations writing checks to the Treasury drawn on various banks and the same thing happens as with the Treasury securities, the banks must meet the demands of the Fed for reserves equal to the amount on the corporate checks being paid. The banks either pay out of excess reserves or borrow the funds in the Fed funds market.

I repeat, this type of borrowing goes on every day.

But something unusual occurred this week. In the past, it was easy for banks to borrow overnight money but not this week.

Beginning during the Great Recession, Bernanke pumped large quantities of reserves in the system, much of it ended up as "excess reserves."  Excess reserves are just that, reserves that banks have an excess of and are available to be loaned in the Fed funds market, and that is pretty much what has been going on. But it has always been loaned out close to the effective Fed Funds rate set by the Fed because there is a lot of competition, that is, lots of excess reserves available. But that didn't happen this week, even though there are still plenty of excess reserves.

Here is the chart on excess reserves:

As can be seen, before the Bernanke reserve pump, excess reserves were always near zero, with Bernanke's pump excess reserves climbed to over $2.5 trillion.

The reserves have now declined to around $1.4 trillion because bankers have used some of it as required reserves to expand their lending and some of it was drained as a result of the Fed's recent quantitative tightening (which has now stopped). 

But that $1.4 trillion is certainly enough to meet demands for reserves in the tens of billions range. So why wasn't the demand for reserves met, with so much in excess reserves? This is the key question.

The Federal Reserve Bank of New York is now examining why banks with excess cash failed to lend to the overnight money market.

John Williams, president of the New York Fed, on Friday questioned the hesitance of the banks in an interview with the FT. “The thing we need to be focused on today is not so much the level of reserves [held at the Fed],” he said. “It’s how does the market function.”

My guess is that the New York Fed will find two chief reasons banks didn't loan out Fed funds as overnight rates climbed.

I wrote this week in the ALERT:

[W]hat could be occurring is that all the easy liquidity has finally been sopped up within the system and that the Fed will have to go back to its old ways. The fact that there are still plenty of excess reserves may not be important. The bankers' "hot money" that was in excess reserves may have all left excess reserves and the excess reserves that remain may be with conservative small-town bankers who are going to keep most of the reserves right where they are until the Fed sticks dynamite under their butts by say eliminating IOER completely which was the case before the Great Recession.
Here is a second factor as explained by Nathan Tankus:
Now here’s where the tricky part comes in. If all that mattered was the liquidity reserve requirement, we’d still have plenty of excess settlement balances and thus ample liquidity. But there are other liquidity requirements! And they showed up recently in Basel 3 

The first of the two liquidity requirements that matter are the “liquidity coverage ratio”.The good news about these is treasury securities satisfy them just as much as settlement balances. In this sense,Budget deficits inject“LCR reserves”.If this was all we’d still be okay 

BUT, and here’s the KEY: there’s a second sheriff in town. This is called “resolution liquidity”. These apply to “Global-Systemically Important Banks” or G-SIB. Remember the desire to have banks have “living wills”? This is part of that.

The idea here is that gigantic banks should be able to meet all their own liquidity requirements without borrowing in short term markets for 30 days. This gives time for central banks to respond ·

The problem is,by making a requirement based on intraday liquidity “resolution liquidity adequacy” is discouraging gross flows. The big banks are now incentivized to hoard liquidity.

This means not absorbing treasury securities when it would otherwise be profitable. This also means that demand for settlement balances is rising intraday. As the demand for intraday liquidity rises and willingness to absorb treasuries fall, repo markets have been tightening.
Below is a Kansas City Fed chart which tends to back up my point.  The excess reserves of the largest global, systemically important U.S. banks (GSIB green line) and  U.S. branches of foreign banking organizations (FBOs blue line) have been declining. That is excess reserve funds have been declining because of past Fed quantitative tightening or the banks have put the reserves into the system. But at the same time, the All Other category (orange line), essentially smaller banks including country banks, has been relatively stable. They just aren't putting their reserves in the system.

So despite plenty of funds sitting as excess reserves, things have changed plenty since the Bernanke pump, some smaller banks are just fine sitting with excess reserves collecting the interest rate on excess reserves, and global banks appear to have hit post-Great Recession regulatory reasons for holding on to the rest of their excess reserves.

So in other words, while excess reserves stand near $1.4 trillion, we may really be at a period like the pre-Great Recession when excess reserves were near zero and excess reserves were not a source of most reserve funding.

Pre-Great recession, the Fed funds rate was much more volatile and the Fed, just like this week, was regularly conducting repo operations.

Here's what Fed funds rate volatility looked like before, during and after the Great Recession.

Thus, Fed President Williams is absoulety correct when he told FT, “The thing we need to be focused on today is not so much the level of reserves [held at the Fed]. It’s how does the market function.”

In other words, if excessive reserves are "sticky" at current post-Great Recession levels because of regulatory reasons and lack of trading desire among small banks, then the Fed will just act like it did before the Great Recession and be regularly active in the repo market.

We are not going to learn later that "institutions were troubled (insolvent)" during this weeks climb in overnight rates. We are going to learn that banks, for various technical reasons, didn't supply reserves while interest rates climbed as a result of Fed demand from banks because of Treasury deposits.

This troubled institution comment indicates a complete failure to understand the overnight funds market.

That said, the Fed being more active in the repo market is not without problems. It is more money pumping activity and that is always bad. It will help extend the boom phase of the current Fed-created boom-bust cycle and put more upward pressure on prices. It will not be pretty when it ends but it is not ending in the immediate future as Austrian-lites are forecasting.

Robert Wenzel is Editor & Publisher of EconomicPolicyJournal.comand Target Liberty. He also writes EPJ Daily Alert and is author of The Fed Flunks: My Speech at the New York Federal Reserve Bankand most recently Foundations of Private Property Society Theory: Anarchism for the Civilized Person Follow him on twitter:@wenzeleconomics and on LinkedIn. His youtube series is here: Robert Wenzel Talks Economics. More about Wenzel here.


George Selgin, Director of the Cato Institute's Center for Monetary and Financial Alternatives, has just tweeted about the turmoil last week which supports my analysis and adds another point as to how the entire turmoil last week could have been avoided:


  1. So with enough negative press, do you expect the Fed to increase the spread on IOER and the Fed Funds Rate, to provide that kick in the pants to lend excess reserves (and inadvertantly cause money supply to boom)?

  2. Thanks for the article RW. Very enlightening.