Why banks shouldn’t blame the ‘repo rupture’ on regulationThe Honorable Sheila C. Bair
Bank lobbyists, like magicians, are skilled at the art of legerdemain. Whenever there are unexpected problems in the financial markets, they are quick to create the illusion of financial regulation as the culprit. In doing so, they divert attention from the real cause, which is all-too-often misbehavior on the part of the banks they represent.
True to form, the banking industry’s lobbyist-supreme, JPMorgan Chase’s (JPM) Jamie Dimon, and others, have been blaming post-crisis financial regulations for recent malfunctions in the “repo” market. However, if anything, this episode suggests regulators need to do more, not less, to stabilize big banks and make sure they can serve as a source of strength in times of stress.
“Repos” are an important source of overnight funding for a variety of financial institutions. In a typical repo transaction, the entity needing cash will sell U.S. Treasuries to a counterparty with an agreement to buy them back at a slightly higher price the next day. While technically a sale, repos are the economic equivalent of short-term collateralized loans. Repos are a particularly important source of daily cash or “liquidity” for nonbanks such as securities firms, money market funds and hedge funds, which unlike banks, cannot store their money in deposit accounts at the Federal Reserve (referred to as “reserves”).
The rate charged in the repo market generally stays close to the target rate set by the Fed for banks’ lending to each other on an overnight basis from their reserve accounts, as well as the rate the Fed pays banks on their excess reserves. In mid-September, when that target was 2.0% to 2.25%, the repo market started to malfunction. Repo rates reportedly skyrocketed as high as 10% and did not settle back to the target range for several days.
Banks didn’t withdraw reserves yielding about 2% and deploy them into repos to capture the much higher rates (until the two rates converged), which is what should have happened if markets were functioning properly. But the banks failed to do so, requiring the Federal Reserve Bank of New York to step in and offer up to $75 billion in daily repo financing.
Dimon and other industry advocates have pointed the finger at post-crisis liquidity and capital rules. These sensible rules require banks to hold a certain amount of highly liquid assets — like reserve deposits and Treasuries — on their balance sheets. They also limit leverage by requiring banking organizations to fund themselves with a minimum percentage of equity. Dimon et. al. have been arguing that these rules create incentives for banks to hoard cash and not lend, thus contributing to the repo bottleneck.
But this makes no sense. For the most part, liquidity and capital rules treat Federal Reserve deposits and U.S. Treasuries as interchangeable. Taking money out of reserves to buy U.S. Treasuries should not have a material impact on banks’ liquidity or capital ratios. It is true that banks’ own risk managers prefer reserve accounts to manage daily cash needs because those funds are easier to tap than Treasuries, which must be sold or posted as collateral to convert into cash. But that is the bank’s decision. It is not required by the rules. The idea that regulations have made big banks risk-averse scaredy-cats is also nonsense. One need only look at their leveraged corporate loans, subprime consumer loans, and esoteric derivatives exposures to know that they are quite ready to take on risk when it suits them.
So why didn’t the banks lend into the repo market?
Perhaps because they didn’t want to. Some of those caught in the repo squeeze were their nonbank competitors. As one industry insider with a top 10 bank told the Financial Times, “We have plenty of liquidity. We are just choosing not to lend it out overnight to hedge funds.” Or, harkening back to the 2008/2009 bailouts, maybe they thought that calming market squalls is no longer their responsibility, but that of the government. They were certainly quick to bash the New York Federal Reserve Bank for not being prepared to step in. Granted, execution by the NY Fed could have been better. However, this was not a crisis situation. Corporate tax payments and new Treasury debt issuance were increasing demands for cash, but these events were hardly extraordinary enough to justify expectations that the Fed would need to intervene.
For its part, JPMorgan Chase says it was sitting on about $120 billion in reserves when the repo market ruptured. Dimon claims that it did not channel those funds into repos because regulators require that the bank maintain that level of reserves to prepare for stressed conditions, or worse, the bank’s failure. It’s impossible to know based on public disclosures whether Dimon’s interpretation of regulatory requirements is accurate. In any event, it does not seem unreasonable for regulators to want a bank with nearly $3 trillion in assets to keep $120 billion in ready cash on hand. The problem would seem to be that JPMorgan Chase — a dominant player in the repo market — was managing its liquidity too close to its regulatory minimums. With more ample reserves, it could have easily stepped in. Notably, Chase had allowed its reserves to drop by over 50% since the beginning of the year.
To be fair, it may be that the financial system needs more banking reserves to function properly. “Excess reserves”— that is, funds banks keep on deposit at the Fed that exceed regulatory requirements — are reported to be about $1.4 trillion. This sounds like a lot, and it is by historical standards, but it represents nearly a 50% drop from the peak in 2014. In its efforts to unwind its own balance sheet, the Fed may have drained bank reserves too far given the massive amount of cash the Federal government is pulling out of the markets to maintain its $16+ trillion-and-growing pile of public debt.
“Primary dealers” — securities firms obligated to make markets in government debt — use the repo market to finance their operations until they are able to sell the securities off into the broader market. Regulatory requirements have justifiably increased demand for reserves and other liquid assets. But a bigger factor may be primary dealers’ need for short-term liquidity to support government debt markets, particularly as demand for Treasuries has been negatively impacted by the inverted yield curve.
So far, Federal Reserve Chairman Jerome Powell has wisely declined to accede to industry demands to weaken regulations. Instead, the Fed has said it will increase the total amount of reserves by about $60 billion a month, at least until the second quarter of next year. This is a step that TD Bank’s Priya Misra and others long have been advocating.
This should not be confused with quantitative easing or “QE,” a controversial program undertaken by the Fed after the financial crisis to inflate financial assets by buying long-term government backed securities. Instead, the Fed will add to reserves by buying short-term Treasury bills from banks. The payments will be credited to their reserve accounts, lessening their need to carry this government debt on their own balance sheets while increasing the reserves available to them to support repo operations and other market functions. An added benefit: The announcement has had a positive impact on the yield curve, which should stimulate demand for Treasuries.
Dimon and other bank lobbyists do themselves and their banks a disservice by launching a full-frontal assault on regulations every time a market disruption occurs. Post-crisis reforms have made the system safer. I am skeptical that banks were really constrained from intervening in repo markets by their liquidity and capital requirements. However, if they were, the answer is to increase their buffers above regulatory minimums, not loosen the rules. By adding reserves to the system, the Fed will help them do so.
This is not to say that regulation is perfect. Regulators need to be mindful of the cumulative impact of liquidity rules on banks’ activities, particularly intra-day cash management. Regulators should also be clear about when banks can use their liquidity to support markets. After all, a bank is not truly liquid if it can’t deploy its cash when market conditions dictate. But those issues do not require rule changes. They can be addressed through constructive conversations between banks and their supervisors.
When we watch magicians, we know they are fooling us. We should have the same skepticism about bank lobbyists’ chicanery. Instead of plotting and planning more campaigns to undo post-crisis reforms, banks should be focused on working with the regulators to ensure smoothly functioning markets, particularly given the challenge of absorbing ever-increasing government debt issuance, which will only worsen if we slide into recession next year. Far from suggesting that post-crisis rules have made the system more fragile, the “repo rupture” suggests that regulators have not gone far enough to ensure banks have the fortress balance sheets they need to support markets during the tumultuous times that may lie ahead.