On Friday, the Fed promised yet again to “do what it takes” by way of an unlimited backstop to stabilize financial markets. At about the same time, former FRB-NY President Dudley sought to calm nervous Nellies, claiming that recent repo-market volatility was just a technical glitch conveniently guiding the Fed to new, even better reserve levels. With $300 billion and counting thrown into this exercise, this is at the least a costly learning experience. Far worse, repo-market turmoil parts the curtain, revealing the imperial U.S. central bank to be a flummoxed Fed as unimpressive as the embarrassed Wizard of Oz. In the years before 2008, the Fed’s flattering fiction was Greenspan’s “Great Moderation.” Since then, it’s been what I’ll call the Great Stability – that is, safer banks mean safer markets. Both illusions pleased internal Fed expectations of perfect objectivity backed by awesome analytical prowess. Their demise proves that central planning done by central banks is no less dangerous than any other kind of central plan.
It turns out that the Fed could have foreseen the repo-market liquidity freeze. All it had to do was assign some of its formidable research capacity to look at what happens not just when all is right with the financial world, but also what happens under stress scenarios. The Fed rightly demands this of banks. Secure of its own omniscience, it never forced the same discipline on its own decision-making.
A literature survey conducted ahead of this memo finds virtually no governmental research on the impact of post-crisis liquidity or capital rules under stress. Perhaps the most on-point research goes back to 2016, when Stanford’s Darrell Duffie and others found that the supplementary leverage ratio (SLR) undermined monetary-policy transmission since banks subject to it ceased to “reserve space” on their balance sheets for low-margin repo intermediation. Add in the liquidity coverage ratio (LCR), and one gets still more stress due to a still smaller supply of cash or other high-quality liquid assets (HQLAs).
Despite this hint, the best indicator of what repo markets without banks look like may well be what repo markets without U.S. banks actually do. To assess this, we look at what happens when banks spurred by leverage and liquidity window-dressing exit the repo market at quarter end. A 2015 OFR paper observed this and the Fed clearly knows that this is still a problem – see its decision to backstop the market until October 10 to get over the quarter-end hump. Global regulators also know the dangers of quarter-end repo downdrafts although they lack the nerve to do much more than demand some new disclosures.
For now, only the Fed knows what foreign banks did during last week’s cash squeezes and whether they also ran. However, it’s at the least clear that no one stepped into the market other than the GSEs (a different issue we will take up in a separate report later today).
It is of course possible to conclude that foreign-bank window-dressing the U.S. repo market is the result of regulatory arbitrage that would be readily cured by application of tough U.S. SLR and LCR requirements. All banks would then be safer, but markets might become even riskier. So far under stress, bank resilience due to tougher rules clearly does not lead to like-kind greater market resilience – quite the contrary.
What to do? There is no chance that U.S. regulators will renege on mandatory over-the-cycle reporting and allow quarter-end arbitrage akin to that allowed in some off-shore markets. Large banks hope for greater LCR and even SLR latitude. However, Chairman Powell made it clear last week that the Fed plans only to solve for greater market uncertainty by taking a still larger market role all its own. This would in the near term amount to renewed portfolio increases in hopes of bulking up bank excess reserves along with some IOER tinkering that could cut into bank willingness to park their funds with the Fed ahead of the next repo scare. However, it’s also not at all clear that large banks would deploy excess reserves as the Fed hopes because they are almost sure to be part of the flight to safety under severe stress.
The Fed seems to share my fear that its own portfolio operations might not have their desired effect. It is thus also renewing action on creating a stand-by repo facility to add to its reverse repo facility and all its other market-intervention tools. As Bill Nelson at the Bank Policy Institute astutely pointed out last week, this may make the market safer, but only because it makes the Fed still more indispensable and market discipline even less relevant to stable finance without taxpayer-backed bailouts.
Safer banks that led to riskier markets are now leading to riskier central banks in a market riskier still due to the absence of private-sector capital ahead of the taxpayer. The absence of market insight and discipline then eliminates a critical buffer against moral hazard. We learned from Fannie, Freddie and the great financial crisis that taxpayer capital in front of private money is a systemic-risk proposition of unparalleled proportions. Now, we’re rolling these big dice all over again.