The BIS’s quarterly review is out, and, not surprisingly, the “central bank for central banks” conducted a review of the short-term funding squeeze that played out in September to dramatic effect in the US.
That episode – which the BIS calls “highly unusual” – served as fodder for all manner of alarmist reporting, both in the mainstream media and across the financial blogosphere, as everyone donned their “repo expert” hats and engaged in a frantic effort to prove their bonafides by expounding on what was clogging up the market’s “plumbing”.
If you ask the BIS, the corporate tax date and coupon settlements don’t fully explain that somewhat harrowing episode. To wit:
US repo markets currently rely heavily on four banks as marginal lenders. As the composition of their liquid assets became more skewed towards US Treasuries, their ability to supply funding at short notice in repo markets was diminished. At the same time, increased demand for funding from leveraged financial institutions (eg hedge funds) via Treasury repos appears to have compounded the strains of the temporary factors. Finally, the stress may have been amplified in part by hysteresis effects brought about by a long period of abundant reserves, owing to the Federal Reserve’s large-scale asset purchases.
The BIS proceeds to delve a bit further into the structural factors, noting the growing importance of the largest US banks and the evolution of their liquid asset holdings.
“As of the second quarter of 2019, the big four banks alone accounted for more than 50% of the total Treasury securities held by banks in the United States – the largest 30 banks held about 90%”, the BIS writes. Meanwhile, the four largest banks held only about 25% of reserves.
The BIS’s postmortem then flags volatility in the Treasury General Account, noting that “the resulting drain and swings in reserves are likely to have reduced the cash buffers of the big four banks and their willingness to lend into the repo market”. Obviously, the rebuilding of Treasury’s cash balance over a comparatively tiny window played a role in the September chaos.
Amusingly, the report also suggests that muscle atrophy might have contributed. To wit:
A reduction in money market activity is a natural by-product of central bank balance sheet expansion. If it persists for a prolonged period, it may result in hysteresis effects that hamper market functioning. For instance, the internal processes and knowledge that banks need to ensure prompt and smooth market operations may start to decay.
And then there’s regulations – those damn pesky regulations:
Moreover, for regulatory requirements – the liquidity coverage ratio – reserves and Treasuries are high-quality liquid assets (HQLA) of equivalent standing. But in practice, especially when managing internal intraday liquidity needs, banks prefer to keep reserves for their superior availability.
During JPMorgan’s third quarter call, Jamie Dimon tacitly suggested that were it not for the onerous regulatory environment, the bank would have been more than happy to step in and help bring things back under control. Elizabeth Warren was aghast, firing off a letter to Steve Mnuchin warning the Treasury secretary not to use the repo squeeze as an “excuse to further loosen rules that protect the economy from these types of risks”.
Finally, the BIS weighs in on FICC-sponsored repo:
Shifts in repo borrowing and lending by non-bank participants may have also played a role in the repo rate spike. Market commentary suggests that, in preceding quarters, leveraged players (eg hedge funds) were increasing their demand for Treasury repos to fund arbitrage trades between cash bonds and derivatives. Since 2017, MMFs have been lending to a broader range of repo counterparties, including hedge funds, potentially obtaining higher returns. These transactions are cleared by the Fixed Income Clearing Corporation (FICC), with a dealer sponsor (usually a bank or broker-dealer) taking on the credit risk. The resulting remarkable rise in FICC-cleared repos indirectly connected these players. During September, however, quantities dropped and rates rose, suggesting a reluctance, also on the part of MMFs, to lend into these markets. Market intelligence suggests MMFs were concerned by potential large redemptions given strong prior inflows. Counterparty exposure limits may have contributed to the drop in quantities, as these repos now account for almost 20% of the total provided by MMFs.
The Fed of course managed to wrest back control of its key rate and generally tamp down the September turmoil with a combination of O/N and term repos as well as the “early” resumption of balance sheet expansion for reserve management purposes, but jitters persist.
Heightened demand for liquidity over year-end showed up in a pair of oversubscribed 42-day operations (here and here), and the likes of BofA’s Mark Cabana continue to warn about the distinct possibility that a “combustible cocktail” of reserve shortage and dealer intermediation constraints (related to GSIB) will catalyze a year-end squeeze, the Fed’s best efforts to avert another bout of pressure notwithstanding.