Federal Reserve’s Repo Market Fix Is No Fix at All

(Bloomberg Opinion) -- With their best intentions in mind, central banks and governments have instituted rules to ensure that financial institutions have enough liquidity to withstand another crisis. But liquidity coverage ratios, high quality liquid assets rules, Basel 3 compliance, global systemically important bank charges, and the soon-to-be-implemented net stable funding ratios have made supplying the all-important repo market’s needs so byzantine that no one really knows what exactly is required, least of all the Federal Reserve.

The Fed understood these new rules posed an uncertainty risk, which is why they regularly surveyed and consulted primary dealers for feedback. And yet, with no real experience with these new rules, everyone was essentially guessing. Add massive issuance of U.S. Treasury securities to meet trillion-dollar budget deficits and by mid-September the all-important repo market broke, unable to handle ever-increasing demand.

The simple fix is to roll back the regulations. Treasury Secretary Steven Mnuchin proposed just this in late October. That was quickly followed by a letter from presidential candidate Elizabeth Warren, who warned him that “These rules were designed to ensure that banks have enough cash on hand to meet their obligations in the event of another market crash,” and that “Banks are reporting profits at record levels, and it would be painfully ironic if unexplained chaos in a small corner of the banking market became an excuse to further loosen rules that protect the economy from these types of risks.”

Warren was not alone. Former Fed Vice Chairman Alan Blinder and former Federal Deposit Insurance Corp. head Shelia Bair also warned that the rules should remain in place.

Instead, the Fed intervened in the repo market by doing what it does best, burying a problem with more money until it goes away. It did this by supplying repo to the primary dealers directly and reserves to the banking system via Treasury bill purchases.

Unfortunately, the Fed made a critical design error in its daily interventions. They are offering to supply repo to the dealers at prevailing market rates. In other words, they are giving the dealers every incentive to take repo from the Fed as opposed to the market. In essence, the Fed has become the lender of first resort when it should be the lender of last resort and offer repo at a penalty rate. The Fed should be willing to help a dealer in need, but it should come at a price.

So, after four months of these Fed repo operations, new problems are emerging. More specifically, the Fed might be going too far and oversupplying this market. The effective federal funds rate is signaling there are enough reserves in the banking system. This month it traded at 1.54%, breaking below the interest on excess reserves (IOER) floor of 1.55% for the first time in 14 months. This is happening as the Fed announces it will continue to plow ahead with Treasury bill purchases and supplying hundreds of billions of dollars of repo supply until April, if not later.

What should the Fed do? It has already telegraphed it will raise the IOER rate by five basis points to 1.60% at the Federal Open Market Committee meeting next week. Presumably, it will also raise the repo offered rate by five basis points to 1.60%. Policy makers should raise the repo rate even higher. Stand ready to offer liquidity, but at a penalty rate.

This won’t fix the problems in the repo market; only rule changes can do that. But at least this will allow the Fed to identify how much supply is needed to get the market back in balance rather than risking a loss of control of the federal funds rate altogether.

The Fed should not be looking to permanently insert itself into the repo market via a standing repo facility. Repo is still a credit market, and, in times of stress, it requires a credit decision when deciding who gets a collateralized loan and at what terms. Central banks are not equipped to make these decisions, and their involvement could create a moral hazard, making things worse.

The repo market’s problems are far from over.

To contact the author of this story: Jim Bianco at jimb@bloomberg.net

To contact the editor responsible for this story: Robert Burgess at bburgess@bloomberg.net

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

Jim Bianco is the President and founder of Bianco Research, a provider of data-driven insights into the global economy and financial markets. He may have a stake in the areas he writes about.

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