Beginning on September 16, 2019, a liquidity squeeze in overnight secured funding markets drove repo rates well out of the federal funds rate target range, requiring an unplanned injection of liquidity by the Federal Reserve Bank (Fed). Adding to concerns for bank treasurers, leading commentators - including former Fed official William Dudley - cited bank liquidity and collateral management practices as a main culprit. While the causes of this disruption are not fully understood, we are advising treasurers to carefully assess the implications of these events for funding and liquidity risk management. Specifically, we recommend that banks increase their focus on the supply and demand dynamics of collateral markets rather than only on underlying creditworthiness and market depth factors currently captured in traditional liquidity risk frameworks.
An imbalance in overnight repo markets first surfaced on Monday, September 16, 2019 when borrowing costs spiked, indicating that there was more demand for reverse repo liquidity than participants were willing to supply. As a result, secured overnight funding rates moved well above the target range of 2.00-2.25%, reaching as high as 9% intraday on the following day (see Exhibit I). In response, the Fed injected $75 billion per day in overnight funding for the next two weeks, the first time it has done so in a decade. These actions helped rates move back into the target range, settling at 1.86% by September 20, 2019 (the Fed had lowered the target range to 1.75-2.00% on September 18, 2019).
The repo market, which is part of the plumbing that keeps short-term wholesale funding markets flowing, has not been headline news since the days just prior to the 2007 financial crisis. As such, the recent events in the repo market have understandably caused anxiety among many market participants. For some monetary hawks, and dollar bears in particular, these events have finally ushered in the long-awaited QE4 that they expected to accompany the rapid march to zero or even negative interest rates. Except unlike during the financial crisis, the events of last week bring into question the Fed’s ability to control its own interest rate.
For Chair Jerome Powell and the Fed the issue is simply maintaining the right level of excess bank reserves through monetary operations – and this view is backed by leading market professionals. According to this explanation, quantitative tightening — which has shrunk the level of excess reserves to $1.4 trillion at the end of August 2019 from a post-crisis high of $4.5 trillion - reduced market liquidity to a level below what is needed by overnight funding markets. While the current level of excess reserves is vastly higher than before the financial crisis, the Fed believes that the need for excess reserves has expanded due to bank liquidity risk management practices (specifically, the need to comply with the Liquidity Coverage Ratio (LCR) by holding high quality liquid assets), an expanded money supply, and reduced repo market support from banks due to tightened capital requirements. As for the events of last week, the disruption was supposedly caused by this tightened level of reserves in combination with a spike in liquidity needs due to a confluence of quarter-end corporate tax payments, a large settlement of Treasury securities, and even Saudi Arabian spending on oil refinery repairs.
On the other hand, while excess reserve levels have fallen significantly, there is no evidence that these conditions are putting a strain on private sector liquidity. As shown in Exhibit II, the long-term trend of increasing private sector liquidity that began during the financial crisis had not reversed course as of the end of the second quarter of 2019. Corporates, an important source of repo market funding through their investments in money market funds, increased their liquidity from $1.5 trillion to $1.6 trillion during the four quarters ending June 30, 2019.
The liquidity profile of the largest banks is equally encouraging. As shown in Exhibit III, the average LCR, purported to be one of the pressure points for repo market liquidity last week, was 121% as of June 30, 2019 - well above the required minimum of 100%.
Looking at bank balance sheets in Exhibit IV below tells the same story. The liquidity ratio, a measure of liquid assets relative to total liabilities, increased from 30% to 34% over the four quarters ending June 30, 2019. Assuming balance sheets haven’t dramatically deteriorated since the end of June 2019 - and there is no data to suggest they have - it is difficult to reconcile the strong liquidity profile of the banking industry with the assumption that quarterly tax payments and other corporate outflows put enough strain on repo markets to disrupt funding conditions last week.
Viewing current repo market conditions from a collateral perspective provides a more complete view than focusing solely on bank reserves. Since quantitative tightening began in earnest at the beginning of 2018, Fed total assets have fallen from $4.5 trillion to $3.8 trillion as of September 11, 2019. As the US Treasury increasingly now must rely on the private sector rather than the Fed as the ultimate Treasury security buyer, supply pressure has continued to build on collateral, including US Treasuries. The events of September 16, which included settlement of $54 billion of Treasuries with primary dealers, served to underline the impact – put simply, we have entered a buyer’s market for high-quality collateral.
Even the possibility of deteriorating liquidity in high-quality repo collateral should be extremely sobering to bank treasurers and prompt questions as to whether their institutions’ funding and liquidity risk management practices appropriately capture the potentially changing risk profile of collateral. The risk of supply and demand imbalance in repo markets for high-quality collateral such as US Treasuries is difficult to assess and in our experience is not adequately considered in current liquidity risk management frameworks, where the focus is on underlying credit quality and market depth. In order to assess their frameworks, bank treasurers should start by asking the following questions:
While the Fed’s intervention in the repo market this month appears to have quelled rate volatility for the time being, absent a satisfying explanation of what caused these recent events, bank treasurers should take a vigilant approach to ensuring their institutions are prepared for future disruptions and make contingency plans in the event that the Fed does not come to the rescue.
Principal, Financial Services Risk Practice, PwC US
Director, PwC US