Fed should prepare for autumn financial plumbing problem

Federal Reserve Updates

If you are a senior Federal Reserve official, you can usually look forward to the Kansas City Fed monetary symposium in Jackson Hole, Wyoming in late August. There you could chat freely with peers while basking in the mountain air of America’s richest city.

Instead, this weekend’s Jackson Hole symposium will be a virtual affair, in part due to the nasty effects of the Delta coronavirus variant that is causing a surge in Covid-19 cases.

The bankers may miss those moments of relaxation on the mountainside. Fed board members have plenty to worry about as US stock prices hit historic highs just as inflationary pressures rage through the economy. If severe market instability occurs this fall, the traditional season of financial disaster, the Fed will be in the spotlight.

I think the Jackson Hole party planners should have focused this meeting on some immediate monetary stability issues. Frankly, few will remember worthy comments from the Fed on the fight against climate change. But what will the Fed do when the world’s financial problems begin to rattle?

There are already some worrying gargles in the system. The Fed has focused on ensuring that US banks have plenty of reserves in their accounts. Yet there are trillions of outstanding transactions around the world that are not directly funded by US bank loans. And these have become more expensive and insecure in recent months.

The international monetary system is increasingly dependent on the availability of collateral to back trillions of dollars in foreign exchange or interest rate swap agreements. These support trade and investment. Regulators want all participants to guarantee their contract performance by pledging “pristine” assets, cash or equivalents not used elsewhere as collateral. Very often US Treasury bills are required, as well as short-term European government debt instruments or sometimes gold.

For the Fed, the main source of liquidity is the reserves it has on deposit, or the nearly $1.4 trillion it holds in overnight reverse repurchase agreements with, say, money market funds or banks. Reverse repos allow institutions to borrow using high-quality collateral, such as US Treasury bills.

However, those reserves and reverse repos require an account with the Fed. They cannot be re-lent before maturity to earn fees and attract other business. That requires collateral such as Treasury bills.

These collateral chains are a critical source of liquidity in international markets. Manmohan Singh, an expert on financial collateral at the IMF, has researched this topic. The international liquidity provided by reselling these pristine assets shrank dramatically after the 2008 financial crisis.

How many securities are reused within the system provides a benchmark. According to Singh, the world’s largest dealer banks held $10 trillion in collateral in 2007, while taking out only $3.8 trillion from hedge funds and securities lending, for a 3.0 times reuse rate.

By 2016, that pledged amount had fallen to just $6.1 trillion, compared to $3.3 trillion in collateral, bringing the reuse rate down to 1.8 times. Fewer institutions trusted their counterparts to return this collateral, contributing to the deleveraging of the financial system. In fact, less credit was available.

Eventually, mutual trust returned. By the end of 2020, this reuse rate had increased to 2.5 times, still below the heady days of 2007.

Unfortunately, we only get this trend data afterwards. So we need to infer what’s going on today from the market prices for Treasury bills and other popular sources of collateral.

But there is another complication. The publicly available supply of Treasury bills has declined. A debt ceiling imposed by the US Congress has a limited issuance. In addition, the Fed’s asset purchases and demand from the major banks have also reduced supply. As an indication, the interest on one-month Treasury bills has fallen this year.

This suggests that there is more demand for pristine collateral. While we don’t have the data yet, the reending ratio could contract again as institutions become more concerned about counterparties, suggesting credit conditions are tightening.

Market odds, such as the drop in gold prices on August 10, indicate systemic tension. Some experts in the gold market and central banks believe that a sudden liquidation of gold collateral occurred when an institution was unable to provide enough Treasury bills.

I would like to propose an additional agenda item for Jackson Hole. The Fed must commit to lend the market some of its $326 billion holdings in Treasury bills in the event of a collateral shortage in the fall. That would provide some extra liquidity for the world’s financial plumber.

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