(Bloomberg) -- Behind-the-scenes regulatory requirements imposed on the largest U.S. banks may help explain one mystery spawned by recent turmoil in an obscure, but important, slice of the multitrillion-dollar money market.
Dealers and policy makers alike have wondered why big banks didn’t step in as rates on overnight repurchase agreements soared to record highs. Those banks have about $1.4 trillion deposited at the Fed.
As these repo yields spiked well above the rate they earn on Fed deposits, banks were expected by many to inject some of that cash into the overnight repo market and pocket the profit. That could have relieved the stress that occurred when a corporate tax deadline and larger-than-expected auctions of Treasury bills suddenly drained the supply of available overnight lending.
As former senior Federal Reserve economist William Nelson wrote in a a blog post Thursday, the higher capital and liquidity rules applied to banks since the financial crisis pose no obvious hurdle to this. Lenders to the overnight repo market receive U.S. Treasuries as collateral, and Treasuries can be substituted for cash reserves and still count as so-called high-quality liquid assets on bank balance sheets.
But there are other, less obvious regulatory hurdles.
Nelson, who now works at the Bank Policy Institute, a trade group representing large financial institutions, said banks also face a clutch of non-public rules that create a strong preference for cash relative to Treasury securities. These include expectations set within stress tests, resolution plans and bank-examiner expectations.
For example, a St. Louis Fed blog in April 2019 noted “internal liquidity stress tests apparently assume a significant discount on Treasury securities liquidated in large volumes during times of stress, so that Treasuries are not treated as cash equivalent.”
Fed examiners, Nelson and his colleague Francisco Covas wrote, also “have expressed a preference -- undoubtedly taken as a mandate -- that banks hold excess reserves rather than Treasury securities.”
Banks might, instead, have borrowed money to lend into the repo market, but that could have pushed their leverage ratios below hurdles set in their stress tests, or risked triggering higher surcharges imposed on globally systemically important banks by the Basel Committee on Banking Supervision.
Finally, Nelson pointed to the stigma that banks face in the event they hit a liquidity shortfall and are forced to ask for emergency funds from the Fed’s so-called discount window.
“The ever-present stigma associated with discount window borrowing has intensified sharply since the financial crisis, when such borrowings often were mischaracterized as ‘bailouts,”’ he wrote. Banks have indicated they “now hold excess reserves in an amount designed to eliminate the possibility of ever having to borrow from the discount window.”
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