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Why I'm Worried About the Repo Market

Narayana Kocherlakota

(Bloomberg Opinion) -- The recent unrest in money markets, which briefly caused short-term interest rates to get out of the Federal Reserve’s control, won’t undermine the central bank’s ability to achieve its longer-term economic goals. That said, it does signal that something’s very wrong with the financial system.

To understand what’s going on, let’s return to a simple model. Suppose there’s only one big bank. It has a choice of what to do with most of its assets: It can keep them on deposit at the Fed, earning the interest rate that the central bank pays on excess reserves; or it can take more risk and earn more return by investing in securities or loans. In this world, all the assets earn the same “risk-adjusted” return, which the Fed effectively determines by setting the interest rates on excess reserves.

Now let’s take a step closer to reality. There are two groups of banks, “tight” ones that hold few excess reserves, and “flush” ones that hold a lot. Flush banks can lend reserves to tight banks in the federal funds market, a focal point of the Fed’s monetary policy. As long as this lending happens freely, all assets will still have the same risk-adjusted return, and the one-bank model will still be a good indicator of how the many-bank world will respond to the Fed’s policies and to various shocks.

In recent days, though, that crucial free-lending condition hasn’t held. On the contrary, a convergence of events -- a deadline on corporate-tax payments and the settlement of a big Treasury auction -- created a sudden and severe shortage of reserves. As a result, interest rates diverged sharply in markets where they should be the same. In the repo market, where participants borrow and lend against the collateral of Treasuries and other securities, they shot up above 5%. And in the federal funds market, they breached the upper bound of the Fed’s 2%-to-2.25% target range.

The deeper issue is that, since the 2008 crisis, regulatory reforms -- such as requirements that banks hold a certain amount of liquid assets, and maintain a minimum leverage ratio (equity capital as a percent of total assets) -- have constrained the ability of flush banks to lend, and of tight banks to borrow. Such constraints interact in complicated ways with financial market conditions. For example, European banks must report their leverage ratios as of the last day of each quarter, so they reduce their repo activity to make those ratios look better. As a result, even when excess reserves seem abundant, funding costs for banks may exceed the interest rate that the Fed controls.

This isn’t necessarily a problem for the Fed’s monetary policy, because the central bank can inject cash into various markets to bring interest rates into line. That’s precisely what the Fed has been doing in the repo market. And it can make the fix more permanent by creating what’s called a standing repo facility, which means the Fed will inject sufficient funds every day, as needed, to ensure that the federal funds rate stays in what it deems the appropriate range.

What’s harder to understand is how money markets will respond to future shocks. As the experience of the past couple weeks has shown, the simple single-bank model no longer works. Reserves are siloed in the flush banks, so the financial system is acting more like it has $1.3 billion in excess reserves than the actual $1.3 trillion. The design of regulation has disrupted some of the system’s most basic functions. The people who oversee it all should be far from sanguine about what the repercussions might be.

To contact the author of this story: Narayana Kocherlakota at nkocherlako1@bloomberg.net

To contact the editor responsible for this story: Mark Whitehouse at mwhitehouse1@bloomberg.net

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

Narayana Kocherlakota is a Bloomberg Opinion columnist. He is a professor of economics at the University of Rochester and was president of the Federal Reserve Bank of Minneapolis from 2009 to 2015.

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