The Fed’s new domestic Standing Repo Facility (“SRF”) makes Treasuries more fungible with reserves and will thus slightly impact the composition of GSIB liquidity portfolios. Post-Basel III GSIBs are required to hold large High Quality Liquid Asset (“HQLA”) portfolios that in practice largely consist of reserves. Although reserves and Treasuries are equal under the letter of Basel III, regulators prefer banks to hold reserves because they are more liquid. This distinction was further highlighted last March when many investors had trouble liquidating their Treasuries. An SRF addresses this concern by allowing GSIBs to instantly convert HQLA securities to reserves. The primary mechanism through which the SRF impacts markets is thus through GSIB HQLA portfolios. An SRF means GSIBs can hold fewer reserves, and more Treasuries. In this post we review the SRF, show that reserve demand is not currently constraining GSIB HQLA portfolios, and suggest the SRF’s market impact will be slight.
The Domestic SRF
The SRF announcement turns the “temporary repo facility” the Fed has already been running each day into a permanent facility. The only major change is it will now also be accessible to banks and not just primary dealers. Recall, an SRF is essentially a stigma free discount window that allows borrowers to instantly convert high quality securities to cash at an above market rate. Its primary function is thus rate control and liquidity provision.
From a rate control perspective, the SRF helps put a ceiling on repo rates by offering to lend almost unlimited cash at a rate equal to the top of the Fed’s target range. The facility may improve sentiment, but will probably never be used. There is ~$1t sitting in the RRP waiting for a chance to earn anything more than the RRP rate, and a few trillion more in banks waiting to earn anything more than IOR. There will be no upward pressure in repo rates for the foreseeable future.
The SRF’s big incremental change is the inclusion of banks as counterparties. From a liquidity perspective, that is unnecessary. Basel III mandates huge liquidity buffers and makes runs on GSIBs virtually impossible. In the event that there are liquidity needs, GSIBs can always borrow from the FHLBs or the discount window. But the SRF will allow regulators to treat Treasuries as more fungible with reserves. A GSIB could now conceivably have a Treasury heavy HQLA portfolio on the claim that Treasuries can readily be converted to reserves at the SRF.
But this only matters if a GSIB’s desire to hold Treasuries is being constrained by its need to hold reserves.
Reserve Demand Is Much Lower Than Believed
Legend has it that the Fed shrank its balance sheet too much and blew up the repo market in September 2019. That is not strictly inaccurate, but it obscures a key dynamic of the episode. It was not the banks who needed money, but the repo dealers. This nuance is important because it shows that banks were not reserve constrained even when system reserves were around $1.3t (vs $4t today).
Heading into September 2019, Treasury repo volumes and rates had been steadily increasing for months. Banks had become the marginal lenders in Treasury repo, which had the same regulatory treatment as reserves but were higher yielding. This was an unstable equilibrium because demand for repo financing was growing even as QT was shrinking the cash available for lending. Eventually, something broke and the repo borrowers scrambled for cash by bidding up repo rates.
Banks were net lenders in the repo market, not net borrowers. They lent hundreds of billions of extra reserves into repo when rates are above IOR, but even that was not enough. If banks had more reserves could keep on lending, but that is very different from saying that the banks themselves were short of reserves. If banks were short of reserves, then the first thing they could do is reduce their lending into repo. They did not do that. In fact, a later survey revealed that the great majority of surveyed banks maintained or increased repo lending during the September repo spike.
During QT the Fed conducted periodic surveys of all the major banks to understand their demand for reserves. The surveys showed that banks largely held reserves to make payments and satisfy liquidity regulations. The surveyed domestic banks (which included all US GSIBS) consistently reported that on aggregate the lowest level of reserves they would be comfortable holding was around $400b. For context, JPM alone held $465b in reserves on the March 2021 quarter-end.
Balance sheet normalization could have continued much longer without any impact to the banking sector, though it would have hurt the repo dealers (and their hedge fund clients). If GSIBs were not constrained by the need to hold reserves back in 2019 during QT, they certainly are not constrained today.
SRF’s Impact Will Be Slight
Liquidity metrics are just one of many factors that determine the composition of GSIB HQLA portfolios. An easy way to see this is how differently JPM and Bank of America, two large universal bank GSIBs, manage their HQLA portfolios. BoA sees that deposit rates are ~0% (and sticky), so its strategy is to hold a securities heavy HQLA portfolio, swap them into floating and benefit from future rate hikes. In contrast, JPM’s strategy is to maintain large reserve holdings until rates rise.
The SRF lowers the minimal level of reserves GSIBs are required to hold by making Treasuries (and other HQLA securities) more liquid. But the need to hold reserves does not to appear to be constraining GSIB Treasury holdings at the moment, so the SRF’s ultimate impact on Treasury demand (and thus rates) will be slight.