A little known facet of the banking system has been circling the news media this month, and it’s been throwing the financial world for a loop. People who are extremely well-versed in how the banking system works have been left guessing, and people with no clue how the system works are just as dumbstruck. Everyone has a different story as to what’s going on, but they’re all obsessing over one minute detail about the system.
The Repo Market.
Is it the next cause for concern, in an economy that seems to be tipping toward recession? Or is it just a normal function of banking that is in the spotlight because talking heads need something to freak out about? Let’s find out.
What is the Repo Market?
Repos, or Repurchase Agreements, are short-term lending contracts. They act similarly to Bonds, in that money is lent from one party to another for a period of time, and that money is eventually repaid, with interest. However, there are several distinctions between repos and other debt instruments that show that they should not be thought of in the same way.
Repos are a form of lending that exists between banks and other depository institutions. In addition, the time duration on repos are very small, and nowhere near as long as the duration of most bonds. Most repos only exist for one night. Finally, repos differ from bonds because money is not being lent for onlythe promise of repayment. With repos, money is lent in exchange for collateral.
To understand the repo market, it’s important to remember why the Federal Reserve sets a Federal Funds Target Range, and not just a set interest rate. The current Fed Funds Rate is between 1.75% and 2.00%. The higher number, we know, is the rate that banks can borrow from other banks, and the bottom rate, consequently, is the rate that banks can borrow from the Fed. If you are wondering why banks would need to borrow money in times other than the Great Recession, you may be surprised to find out that banks borrow more than you’d think.
Contrary to popular belief, we do not live, nor have we likely ever lived, in a banking system there the money you deposit is stored in an account for you to eventually withdraw. We live in a Fractional Reserve Banking system, where banks can take the money you deposit, and lend out most of it. They lend out your money to try and make a return, in the form of a mortgage, business loan, or whatever else. But what’s important to understand is, at any given time, banks are significantly less flush with cash than they would appear.
So if they aren’t holding all your money as cash, what are they holding it as, and how are they worth enough to be Too Big To Fail? Banks invest most of your money in things like loans, but they also buy significant amounts of Government Debt, or Treasuries. U.S. Treasury Bonds are considered the safest investments in the world because they are backed by the full faith and credit of the U.S. Government, which has never once defaulted on its debt. Banks hold a significant amount of these ultra-safe assets, and are thus considered to be well capitalized, even though their cash positions may not be so large. More on this later.
Of course, your money shows on your deposit slip or account screen as “yours”, and you are free to withdraw it at any time. The bank is on the hook to come up with that money when you do eventually withdraw it. But if your bank suddenly has a lot of customers wanting to withdraw their money at once, the sum total of those withdrawals may be more than the cash position the bank is holding at the time. How, then, is the bank to pay out all those withdrawals?
This is where the Repo Market steps in. When Bank A is in need of capital (cash) but is instead holding too many assets (for simplicity’s sake, we’ll stick with Treasuries for this category), they can offer to exchange their assets for capital on the open marketplace. Bank B, a bank with too much capital relative to its asset holdings, may look at Bank A and think “I can make money off this situation,” and lend the first bank some of its capital, in exchange for some of that bank’s assets. Bank B gets a portion of the assets’ return as a result of holding them for a time, and Bank A gets enough capital to pay its customers. if this transaction were an Overnight Repo, the banks would then re-exchange their positions the following day, when Bank A would have more capital coming in via lending and deposits, to repay Bank B. Bank B would also be paid an interest rate, which, as you read above, would be the upper bound of the Fed Funds Rate, currently an annualized 2.00%.
The Fed Steps In
So now we know how repos work, but what’s making them creep into the headlines? Surely this all seems like normal banking operations? Yes, and no.
Recently, the Fed has been stepping into the repo market, to extend capital to banks in the same fashion as the example above. This shouldn’t normally need to happen, as the marketplace dictates the price for overnight lending, and banks should be seeking a return through the market. The Fed has had to step in, however, because over the last two weeks, the repo market has seen its interest rate climb much, much higher than its usual Fed Funds Rate upper bound. On Tuesday, September 17th, the Repo rate shot as high as 8%. What this shows is banks are either unwilling or unable to participate in the repo marketplace, and as a result, demand for capital has risen to a price four times greater than normal.
There are some issues to the Fed stepping in and playing the part of a bank for these forms of lending, and warning, here’s where we get a little technical.
The Fed stepping into this market is not the same as another bank, because the Fed uses a different form of money. In fact, there are two forms of money in the banking system. There is the normal money used by you and me, normal people, which we store at banks. The second form of money is called Reserves, which is a special kind of money used to denote deposit levels that banks have at the Fed. Remember, the Fed is to the banks, what the banks are to you and me.
When money is created, the Fed loans that money to a bank, which that bank can then lend out to you and me. But in exchange, that bank must keep an account at the Fed with the same amount of money, but in the form of Reserves. When banks need to pay out customer withdrawals, they lower both their money position, and their Reserves position in their Fed account. It is in this way that the Fed can more closely control the money supply, through double-entry accounts through its customers, the banks. Think of it as a three-tiered system, where you, the individual, has an account at your bank with some money in it, and that bank, in turn, has an account at the Fed with the exact same amount of money, but in the form of Reserves.
Now, why is any of this important? It has to do with the Fed’s Balance Sheet. A Balance Sheet measures an entity’s financial position at a given point in time, showing things like how much assets they have relative to liabilities, and how much profits they have built up over the years. You have your own personal balance sheet, too, if you take a total of all your assets (your bank account & investment values, your jewelry, house, car, etc.) and subtract out your liabilities (your mortgage, car loan, student loans, etc.), you’re left with your equity, or Net Worth.
The Fed’s Balance Sheet is unique. It tracks every dollar of money held by individuals as a liability, but also tracks every dollar of Reserves held by banks as an asset. In this way, the Fed can see how much money is in circulation, and can control it by raising or limiting Reserve Requirements, or the amount of money banks are required to have as reserves at the Fed.
For years, the Fed’s balance sheet rose ever so slightly, keeping pace with the overall size of the economy, and its reserves would increase with the money supply. But then the Great Recession happened, and the Fed bought up trillions of dollars’ worth of treasuries and mortgage bonds through the process of Quantitative Easing, expanding the balance sheet from a pre-crisis $800 billion to a post-crisis $4.5 trillion. And as you know from reading my previous blogs (got you!), while this greatly increased the money supply, giving banks liquidity when they needed it most, it also increases the sum of Reserves by the same amount. Through subsequent legislation, regulation, and a bit of complacency by the banking system, banks and the Fed continued to have massive balance sheets through most of the post-crisis period.
And then, in October of 2017, the Fed decided that Quantitative Easing was to come to an end, and stopped reinvesting the proceeds of its new holdings of treasuries and mortgage bonds that were expiring. This caused the Fed’s balance sheet to slowly decrease over time, and by December of 2018, it had been reduced to about $3.7 trillion. But since the rules constraining banks’ ability to lend have not been materially changed since the aftermath of the Financial Crisis, banks are increasingly reliant on there simply being more liquidity in the marketplace in order to facilitate these transactions. Put simply, there was too much money in the system for too long, and now, the system has become reliant on there being too much money.
(I could go into more detail here, on exactly what rules changed regarding banks’ ability to lend, loan, and “make markets”, but that deserves its own post. Suffice it to say, after the Financial Crisis, the rules got a LOT tighter. If you’re interested, give the Dodd-Frank legislation of 2010 a read, to start.)
What’s the Problem?
So what makes this particular episode the cause for such concern? Everyone has their own theory as to what caused the run on liquidity, here are some suggestions:
- The middle of September was one of the major Corporate Tax deadlines, so many bank accounts were withdrawn to make payments.
- Banks are unable to jump into markets like the Repo Market as easily as they used to, because of increased regulation from US and European governing bodies.
- September 16th was also the day that a $78 billion worth of treasury securities were supposed to settle at auction, meaning $78 billion of cash would be turned into treasuries.
Ultimately, they lead to the same conclusion: banks are under-capitalized and would rather not use the reserves they have to pay their customers’ deposits. So the Fed had to step in.
Here’s why that isn’t a problem.
I stated above that the Fed is to the banking system, what the banks are to individuals (you and me). The Fed is commonly referred to in Econ 101 as the Lender of Last Resort, meaning if banks do not have another lender, they can go to the Fed. The Fed Funds Rate has a target range of two different points because of this.
Here’s where we speculate. One could argue that in the post-crisis world, we have still not seen a return to “normal” financial conditions. The Fed has increasingly relied on Reserve Ratios to gauge the money supply, and not the Fed Funds Rate, which had been stuck at its effective zero-bound until December of 2015. The Fed has even created new tools to govern monetary policy to this effect, such as its Interest on Excess Reserves, or the amount of interest the Fed pays banks on reserves those banks keep at the Fed. The Fed has been lowering the IoER rate to the lower end of the Fed Funds Rate, to keep the two policy tools symmetrical, but they act very differently.
As a result of there being more emphasis on bank reserves, the system has likely become so accustomed to being flush with liquidity, that when that liquidity started decreasing, the system could no longer function properly. Like it or not, the post-crisis economic system is one with outrageously high bank book values, propped up by massive Fed reserve accounts, and as a result, way too much money in the system. It’s called many things, such as a Global Savings Glut, Modern Monetary Theory, or Too Big To Fail, but it all means the same thing at the end of the day. A banking system with way too much money in it.
And this is OK. This is the new normal. Whether or not you agree with it being OK is up to you, and likely has to do with you seeing any of that aforementioned “way too much money”. Chances are, you aren’t seeing it. But that’s how the system works, and for 10+ years after the worst financial disaster in all of our lifetimes, it’s worked pretty OK.
Back to our issue with Repos. I believe the Fed entering the repo market is just the Fed reacting to the banking system clamoring for a return to the ultra-high liquidity of the immediate post-crisis era. The Fed has been shown to be able to create reserves when it needs to, we learned this from Quantitative Easing. So when the banking system needs its medicine, the Fed will step in, and will continue to step in.
The reason why this isn’t an issue, at least for now, is because the Fed is only stepping into the repo market. By its very nature, the repo market ensures that any reserves the Fed creates will be traded for reputable collateral (treasuries), and then traded back in a short time, canceling the increase in reserves. The Fed is, in this way, providing liquidity to banks who need it, while also not permanently increasing the money supply like they did during Quantitative Easing. If this continues the same way it’s going now, there shouldn’t be any cause for concern. But if this spills over into other markets, and the Fed will have to issue reserves without collateral and permanently increase its balance sheet, that’s a different story. However, we’re not anywhere near there yet.
Did you make it through all that? Did any of it confuse you? If so, good. It’s supposed to.
The financial world likes to use what amounts to its own language, to distract or confuse people, and to make them less knowledgeable, and willing to learn, about what the financial world does. That’s why one of my goals with this blog is to educate about these complex topics in an easily understandable way.
If you’ve read this far, thank you! This is one of the more dense posts to come out of this blog, and I commend you. If you have any questions, please leave a comment below and I will answer in the most detailed way I can. Enjoy!