Repo Crisis Sheds Light on Short-Term Funding Markets
Through its recent repo mediation, the Federal Reserve may actually have created a moral hazard in the
Friday, November 8, 2019
By Brenda Boultwood
In September 2019, when a shortage of short-term fund supply caused the repo interest rate to soar, Fed intervention was required to keep it under control. At the time, some wondered if this event was similar to the 2007 intervention that many now see, with hindsight, as a harbinger of the 2008 financial crisis.
In the aftermath of the Fed's recent intervention, important questions have been raised, about, for example, how repo markets and leveraged loan markets are interconnected, and why non-bank financial institutions (NBFIs) are now looking to the repo market for short-term liquidity.
Regardless of the chain of events, we find ourselves today in a world where Fed repo market intervention is supporting the balance sheets of hedge funds and broker-dealers, and, in turn, the market for corporate loans. Of course, as there is never a single answer to phenomena in financial markets, the reasons for Fed intervention in the repo market are numerous.
Repurchase, or repo, contracts allow participants to trade short-term funds, usually at an interest rate that mirrors the federal funds rate set by the Fed. Participants in this short-term lending market borrow cash overnight (typically, for a fee of 2.5%) in exchange for Treasuries and other high-quality collateral, like mortgage securities.
Prior to 2014, and particularly before the 2008 financial crisis, repo market supply was from large banks buying securities and supplying cash in order to maximize overnight returns. Demand was often from other banks. In recent years, in contrast, repo market demand has come from NBFIs, including hedge funds, broker-dealers and real estate investment trusts (REITs).
Let's now take a closer look at the events that transpired, and then explore how the funding of banks and non-bank financial institutions is evolving.
How We Got Here
On Monday, September 16, repo traders were calm, but knew things could get interesting due to end-of-quarter corporate tax payments and Treasury settlements. Pressure had been building in the short-term money markets over several months, largely driven by increased demand from NBFIs to access cash through this short-term funding market.
Repo rates gradually increased to 6%, reflecting a stressed market with more demand than supply. On Monday evening, there was concern that the market could become more stressed, but the Fed was silent.
Markets opened Tuesday morning (9/17) and repo rates rose from 3% to 10%. The volatility drove the market to stall, and the Fed announced late Tuesday morning that it would step in to provide cash, acting as a lender.
The first Fed operation caused repo rates to fall. Subsequently, at the end of Tuesday, the NY Fed signaled they would conduct an overnight repo operation, continuing with the 24-hour lending strategy.
Meanwhile, the Federal Reserve Open Market Committee met the same week and decided to lower the federal funds rate to 2-2.5%. Because repo rates generally align with this rate, the culmination of Fed actions calmed the repo market.
Through October, the Fed's daily cash injections and longer-term repo transactions continued.
Market Implications: A New Round of QE?
Amid all of the chaos, the logical question to consider is whether there was/is a real need for Fed repo market intervention. No single explanation stands on its own, but the result has clear implications for risk managers.
The Fed must organically grow its balance sheet by buying Treasury assets to keep up with the physical growth of currency (a liability). Since the crisis, the Fed's currency growth has been about $90 billion annually. This explains a small portion of its balance sheet growth.
Noting the fundamental shortage of global US dollar liquidity, some market watchers predicted the Fed's repo intervention. Indeed, these market observers elaborated, a short-term funding liquidity crisis had been brewing for decades.
What's more, bank efforts to create global dollar liquidity - through their FX books, repo market lending, commercial paper and off-balance sheet derivatives - had shrunk. Problematically, as a result of post-2014 regulations, banks also view their dealer role as riskier today than pre-crisis - partly because of intraday liquidity and higher capital charges on short-term assets.
Aside from these banking issues, the Fed also may take politics into account, potentially compromising its independence. One question that needs to be asked is whether the Fed, in an effort to support the economy and the election cycle, is being forced into quantitative easing (QE) in disguise.
To jumpstart the economy, between 2009 and 2015, the Fed bought Treasuries through its QE policy, increasing its balance sheet from $1 trillion to $4.5 trillion. However, since 2015, as its confidence in the economy has grown, the Fed has moved in the opposite direction - shrinking its balance sheet to $3.8 trillion as part of its quantitative tightening (QT) program.
Prior to 2015, the liquidity provided by the Fed largely went into reserves of largest banks. In fact, bank reserves were near zero before the 2008 crisis, before peaking at $2.7 trillion and leveling out at $1.4 trillion (today).
Now, however, the Fed is back to buying Treasury securities, this time to support the repo market. Fed Chairman Jay Powell has strangely said that this is not a new round of QE.
The Increasing Repo Reliance of NBFIs
Hedge funds and broker-dealers have relied heavily on the repo market to help fund their growing portfolio of securities, especially corporate bonds. However, with banks less willing to provide loans at the repo rate, the short-term funding market for NBFIs now faces a shortage of suppliers. (Pre-crisis, the NBFIs would have relied on bank loans and the repo market.)
Today, given the inadequate Treasury demand, the large bank prime brokers have been forced to hold more Treasuries, draining bank capital from lending and other business activities. However, the new rounds of QE in the repo market have increased the demand for Treasuries, allowing the brokers to reduce their Treasury inventory and enabling banks to sustain lending activities.
The heavy reliance of hedge fund and broker-dealers on the repo market is rational, given that they appear unable to fund their short-term cash needs through either bank loans or asset sales to the large banks.
The Shift Away from Banks
Where have the traditional repo market lenders gone? Well, banks now have little incentive to lend in the repo market, which has declined from $4.3 trillion, pre-crisis, to $2.2 trillion today.
First, banks get paid interest by the Fed. If, for example, a bank's IOER is 1.8%, with no capital requirement, its return on equity is 1.8%. In contrast, to provide regulatory capital-adjusted returns on par with IOER, repo rates must would have to be above 14%.
The second reason that banks do not want to issue repo loans is because they incur extra capital and liquidity charges on short-term loan exposures under post-crisis Basel rules. The LCR, for example, requires banks to hold cash reserves sufficient to keep their operations going in a crisis. Moreover, it does not include Treasuries and requires banks to track intraday liquidity - to understand the amount of cash that can be immediately accessed.
Through its repo market intervention, the Fed has stepped in to replace banks, which continue to shrink their balance sheets.
However, a few key questions remain: (1) Why aren't banks lending directly to the NBFIs? (2) Do the banks know something about the balance-sheet and corporate-loan-asset quality of the largely privately-held broker dealers, hedge funds and REITs? (3) Finally, will more QE solve the problem?
If the large banks simply use the new round of QE to further add to their excess reserves, the answer to the latter question is certainly no.
A Flawed Proposal
The St Louis Fed has proposed the creation of a standing repo facility that would act much as the Fed did in the period after September 16. There are, however, two primary issues with this strategy.
The first is that if the Fed is the back-up emergency lending source in the repo market, it will be more complicated for the central bank to establish monetary policy to set short-term rates, via the Fed funds rate and the IOER.
The second reason is because such a facility could create a perverse incentive, providing support for non-bank holdings by broker dealers and hedge funds of lower quality corporate debt. This could raise concern about the corporate debt market, which now sits at 74% of US GDP.
In short, repo market intervention could stabilize the short-term funding market by satiating current Treasury demand, but also cause greater risk in the longer-term corporate debt market.
Parting Thoughts: Risk Management Implications
The Fed's intervention in the repo market provides three take-aways for risk managers.
Firstly, it's clear the Fed does not have the analytics to understand long-term trends in the global demand for dollars. Since January 2019, Fed Chairman Powell has operated under an “ample reserve policy” - a plan that commits the central bank to providing a sufficient supply of reserves without interfering with its strategy to reduce interest rates gradually.
If the Fed winds up permanently participating in the repo market to avoid future imbalances, it could complicate the task of implementing monetary policy. Indeed, under this scenario, the question would be whether the Fed could execute a meaningful monetary policy through interest rates and money supply, while being unable to predict either.
Secondly, permanent Fed intervention could also create an incentive for repo market participants to take excessive risks, at a time when there might already be too much leverage in the corporate debt market. The Fed initially intervened to fix the mismatch between supply and demand. It is now clear, however, that the Fed intends to continue intervening in short-term markets, thereby boosting its balance sheet and partially reversing QT. (If the next liquidity crunch affects primarily broker-dealers, hedge funds and REITs, will that be considered a financial crisis?)
Lastly, risk managers must stay on high alert for other anomalies. Troubles in the repo market could alarm investors, leading to a shortage of supply in short-term markets - similar to what occurred at the start of the global financial crisis.
Clearly, conditions today are dissimilar to what happened a decade ago. Still, economic troubles often begin when investors panic because of perceived shortages of funds. Thus, to avoid panic, the Fed might have no choice but to continue intervening.
Brenda Boultwood is a Risk Advisory Partner at Deloitte. She is the former senior vice president and chief risk officer at Constellation Energy, and has served as a board member at both the Committee of Chief Risk Officers (CCRO) and GARP. Prior to joining Deloitte, she was a senior vice president of industry solutions at MetricStream, where she was responsible for a portfolio of key industry verticals, including energy and utilities, federal agencies, strategic banking and financial services. Before that, she worked as the global head of strategy, Alternative Investment Services, at J.P. Morgan Chase, where she developed the strategy for the company's hedge fund services, private equity fund services, leveraged loan services and global derivative services.